Editor's Note: This article cites a 6-month early termination fee on Synchrony Bank's 5 year CD product. In 2016, Synchrony Bank's terms and conditions were changes so that the early termination fee is now 1-year of interest on the CD.
The last couple of weeks have seen virtually unprecedented volatility in the US bond markets. While some analysts (perhaps most notably Deutsche’s Joe LaVorgna) say that the Fed could surprise markets and raise rates as early as June 2015, we have also seen the 10 year Treasury fall below 2% as a result of Ebola and global market fears.
As a result, the most sensible strategy for money that you do not anticipate needing for a period of time is to buy bank issued CDs, specifically 5 year CDs. By so doing, you are coming to terms with the likelihood that low rates may be here to stay for a reasonably long period of time and, thus, finding a safe way of getting higher yields than savings or money market accounts now offer and at the same time protecting yourself from the possibility of seeing the 10 year Treasury rise above 4% before October 2015. Bank issued CDs, especially 5 year CDs, offer higher yields than savings. Some banks also provide an option against a sharp move in Treasuries in the form of attractive early withdrawal penalties.
Should interest rates move dramatically higher, bonds – even short duration bond funds – will move dramatically lower. We saw fixed income values fall in mid-2013 as the 10 year Treasury moved from 1.50% to 3.00%. The more relevant historical precedent remains the late 1970s when oil and food shocks boosted inflation and yields increased to double digit levels, leaving bond and bond fund holders with negative real income returns and punishing capital losses.
Certificates of deposit do not bear the same risk. Should interest rates rise from their current levels and a long-term CD cease to produce competitive yields, investors usually have the option to withdraw the balance in part or in its entirely, forfeiting only an early withdrawal penalty calculated as a percentage of interest earned. The early withdrawal penalty will cut into some interest earned, but it can only reduce principle if one withdraws very early in the term.
Early withdrawal penalties among the most highest rate online issuers of 5 year CDs are as follows:
Synchrony Bank – 6 months
Barclays Bank – 6 months
GE Capital Bank – 9 months
CIT Bank – 1 year
Nationwide Bank – 1 year
EverBank – 15 months
A six month penalty only is particularly attractive. Synchrony Bank is currently offering 5 year CDs at 2.30%. An investor placing, say, $200,000 in such a CD with one of these banks would receive more than $24,000 gross over the next 5 years, compared to about $10,202 were the same monies invested in a 1% savings account.
In 5 years, a 5 year CD will outperform a savings account and will have generated a decent premium over the savings account, should savings rates stay where they are. However, if interest rates were to significantly rise in one year, the investor could exit the CD, paying only a $2,300 early withdrawal penalty (six months interest), and still have their entire principle plus $2,300 in interest. Under such a circumstance, the effective return of the 5 year CD in the first year would be 1.15% - still better than any currently offered savings or one year CD rate.
Similar calculations show that yields on a five year CD can be still better than shorter term CDs in years two three and four, even when investors pay an early forfeiture penalty. In fact, the further away an increase occurs in interest rates in the United States, the better will be the positive impact on earnings from a 5 year CD with a six month withdrawal penalty. For example, the effective return of a 5 year CD held for 4 years may outperform that of a 4 year CD, even if the investor pays a six month early withdrawal penalty at the beginning of year 4.
The option that you are getting inherent in a CDs early withdrawal penalty is valuable. While rates may rise quickly over the next year, these options offer depositors significant safety and security that bonds and bond funds do not.
For these reasons, 5 year CDs are particularly compelling at this point. However, before making any purchases, you should always check to be entirely sure that you understand the early withdrawal penalty.