Callable CDs

June 1, 2006

Imagine getting an FDIC-insured 6.5% return with zero risk! Too good to be true? With Callable CDs you can get mouthwatering returns without the ups and downs of stocks. Trouble is, you can’t have your cake and eat it too.

CDs (certificate of deposit) are appealing to risk-averse investors. They are FDIC-insured against loss (unlike mutual funds) and readily available with just a few thousand dollars at your local bank – seemingly without sales charges or commissions.

With interest rates on the rise, CDs are becoming more attractive, particularly to those worried about stock market gyrations and low dividend yields from stocks.

Because of the safety, CDs typically don’t yield much – the best CDs yield slightly more than government bonds for similar maturities. As interest rates have climbed in recent weeks, investors can typically get around 4% - 5.5% on better CDs, depending on the term.

Some CDs have higher yields than others – even for the same time period. As all bank CDs are FDIC-insured and there is no expense ratio (or manager or other considerations), gravitating toward the highest-yielding CDs is appropriate. Websites like make researching CD yields easy, and most investors will find they can do better shopping around online than at their local bank branch – in fact, they will likely do better in their discount brokerage account or online bank.

Right now I can buy a three-year CD at E*Trade yielding 5.3% APY (Annual Percentage Yield includes compounding), 5.32% at Scottrade, or 5.21% in my Netbank online account.

My local Chase branch? 4% APY for a three-year CD – and that’s only because I have a checking account at Chase. 1.3% a year is a big difference – you’d earn around $420 more over three years on a $10,000 CD at E*Trade than with Chase.

Some CDs appear to offer better returns than the yields you see at the best CD outfits, which tend to be the same places.

In all likelihood, these are known as “Callable CDs”. Unlike ordinary CDs – which make up 99%+ of all CDs – callable CDs can be 'called in' by the bank, much like a callable bond. Most callable CDs are available through brokers, as are ordinary CDs. Some are available direct from a bank.

Callable CDs offer tantalizing yields that are generally about 0.5% – 1.5% more than regular CDs for the same term – almost what you’d get in a high-yield corporate bond fund (like Vanguard High Yield Corporate VWEHX fund, which currently yields 7.06%) only with no risk (unlike the Vanguard fund).

Here is how these callable investments work:

A traditional, or “bullet” CD has a term of, say, five years. While this is a risk-free investment, it can be a bad investment. Risk is defined as the chance of losing money, not giving up extra returns. Imagine walking into a bank and buying a five-year, 5% CD. Two days later interest rates take off on inflation fears and the same bank now offers a five-year, 6% CD. While you didn’t lose any money, you are locked in at 5% for five years when you could have gotten in at 6% for five years.

On the flipside, if interest rates fall sharply two days after you step out of the bank, you are sitting pretty – you have a five-year, 5% CD while new customers are getting five-year, 3% CDs. This is why CDs are very similar to owning government bonds of the same maturity: you get the rate you signed up for, but you benefit if rates fall after you buy, and are hurt if rates climb after you buy. With bonds, you can see the changes in value daily: if you pay $1,000 for a five–year, 5% bond today and rates drop sharply tomorrow you can probably sell it for $1,050 or so as your bond has a better yield than other bonds. In theory you could sell your CD at a premium, but CDs are hard to trade, which is why government bonds can be a better investment.

Back to the magic extra yield. If interest rates fell to 3% you would not want a bank executive to call you and say, “Remember that CD you bought that pays 5% for five years? We want to give you your money back and not pay you 5% for five years. We’ll give you 5% for one year and call it a night, okay? There is no need to raise your voice. You can buy another CD for four years with a 3% yield. Now you’re just being greedy. Good day, sir!” .

A callable CD is a CD the bank can cash in when they want to (once it becomes callable). Clearly this is worth less than a traditional, non-callable CD, as you can’t even bank on a 5% yield for the full five years. This is why banks pay you more for a callable CD – they are rewarding you for the risk that you may not earn the juicy return for a full 5 years. In fact, unless interest rates climb, they will likely call the bond.

Such an investment leaves you suffering when interest rates go up (you could have bought a higher-yielding CD) and suffering when rates go down (you are given your money back to reinvest at lower yields). A money market fund has a better risk-to-reward ratio because your yield may go down if rates fall, but your yield will go up if rates increase. For reference, Vanguard Prime Money Market Fund currently yields 4.7% – and you can write checks or simply liquidate the account whenever you want!

There are scenarios when a callable CD is a good deal. If interest rates stay flat or drift up slowly over the life of the CD, the bank probably won’t call it in and you would have done better in the Callable CD than in a regular CD or with a money market account.

However, the extra yield is probably not worth the risk – we’d like to see a 1% premium per year to consider callable over traditional. Right now a five-and-a-half-year callable CD available through Scottrade yields 5.83% APY, while a similar five-year CD yields 5.54%. Don’t sell off your upside for a lousy 0.29% a year!

A big word of caution: Callable CDs can be very long-term, like 10 to 20 years. The call provision is only one year. These are pitched as “6.5%, one-year callable CDs – FDIC-insured!”. YOU CAN’T CALL THE BOND in a year, only the bank can. You are stuck for 20 years.

A comparable investment is a callable bond. Callable bonds also pay higher yields than traditional bonds because the issuer can give you your money back when you don’t necessarily want it (when interest rates are lower). And unlike CDs, you can sell callable bonds.

Bottom line: Callable CDs are not a terrible idea but are illiquid, don’t have enough spread over regular CDs, and can leave you with a lump of money when interest rates are low. These CDs might be better for those who don’t need to live off investment yield and can gamble with the risk of getting their money back in a low-rate environment.