Over the last decade, many ways investors have traditionally sought income were less than ideal. Thanks to the Fed’s zero interest rate policies, a variety of fixed income products paid next to nothing. “Cash is trash” was the mantra. But these days, cash is alive and well. And some very old-school income products are now actually paying decent yields and worth paying attention to.
We’re talking about certificates of deposits (CDs).
Right now, CDs are paying yields not seen in nearly 10 years and offer a chance to lock up secured income during the constrained market environment. For conservative investors or those either nearing or actively in retirement, the humble CD could be a wonderful alternative for their fixed income portfolios.
Don’t forget to check our Fixed Income Channel to learn more about generating income in the current market conditions.
From Zero to Nearly Five Percent
Back before the Great Recession, investors could do something unimaginable – they could live off of their interest from safe fixed income investments. However, with the credit crisis, the severity of the downturn and the need to jumpstart the economy, the Federal Reserve slashed rates in a big way. All in all, the Fed reduced benchmark rates from 5.25% to 0%, and that was before the various quantitative easing and bond buying programs.
Those rates sat at zero for the better part of a decade. For fixed income investors, traditional income products paid almost nothing. To that end, exotic asset classes like senior loans and master limited partnerships (MLPs) thrived.
But with inflation rising, boring fixed income products may be having the last laugh once again. To combat the problem, the Fed has started to raise rates and is currently on a path to continue raising them until we hit levels roughly seen before the Great Recession. For investors seeking stability and safety of income, these are the halcyon days once again.
CDs Are Looking Good
And you can’t get much safer than a humble certificate of deposit (CD).
Essentially, a CD is a savings account that is fixed in both initial deposit and time. In exchange for holding your money for six months, a year, two years, etc., the issuing bank will pay you a set interest rate that is locked in at the time of purchase. More often than not, this rate is higher than what you would get on a regular savings account.
CDs can be issued by banks or purchased through various brokerages on the secondary market. And while they lock up your money for a fixed period of time, investors have the ability to end their CD early minus some fees and loss of interest.
So, why should conservative investors consider them? For starters, guarantees. Because they are issued by banks, certificates of deposits feature FDIC insurance, which makes them safe in the case of a bank default. Secondly, investors know exactly how much interest and return the product is going to generate over a given time. And speaking of that interest, depending on the terms of the CD (and length), many banks will pay that interest monthly or quarterly as cash to a checking or brokerage account. This allows investors to have a stream of income from a very safe investment.
The best part is that CDs are once again paying some actual interest to their investors.
Thanks to the rise in rates, CDs’ yields have gone from about 1% to well over 4.5%. According to Fidelity, investors can score a 12-month CD at a 4.65% rate. Even locking money up for 3 months still nets you 4.25%. That’s a pretty good guaranteed return considering the safe and secure nature of the product.
How to Use Them
Given that rates on CDs are now juicy, conservative investors may want to consider them for a portion of their portfolio. They’re not designed to make you rich, but they can provide a non-volatile way to generate decent income. Buying them is a snap. Logging into your brokerage’s site, going to your local bank branch in person or visiting an online bank’s website and clicking “buy” is all you need. Just be aware of the terms and how the interest is credited before purchasing. The absolute highest yield may not be the best overall option for your needs.
Another great choice? A CD ladder.
CD laddering is essentially buying multiple CDs at different maturities. For example, 1-year, 2-year, 3-year, 4-year and 5-year CDs. The idea is that nearer-termed CDs will yield less and further-dated CDs should yield more. The blended yield of the ladder would be still high. However, investors always have a portion of their savings becoming available (the maturing CD) each year. They can invest that in another later-dated CD if rates are high, or they can look for other options if rates are falling. CD ladders can also be used in order to time purchases or spending in retirement.
The Bottom Line
Certificates of deposit accounts were left for dead in the world of zero percent interest rates. However, they now offer a real solution for fixed income investors. Thanks to their safety and security, they are great choices for portfolios. And now with yields above 4%, they are real income producers as well.
Take a look at our recently launched Model Portfolios to see how you can rebalance your portfolio.
