5 Year CDs - A Safe Option In An Uncertain Interest Rate Environment

5 Year CDs - A Safe Option In An Uncertain Interest Rate Environment

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CDs, in particular many online five year CDs, are a safe option in the current interest rate environment.

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.

See BestCashCow.com’s compound interest calculator

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.

See the best 5 year CD rates here.

EverBank's 3 Year Marketsafe BRICS CD Is Not A Certificate of Deposit At All

EverBank's 3 Year Marketsafe BRICS CD Is Not A Certificate of Deposit At All

Rate information contained on this page may have changed. Please find latest cd rates.

Until October 15, EverBank is offering a 3 year product that gives investors the opportunity to participate in the upside of a basket of 5 currencies (Russia, India, China, Brazil and South Africa) in what it calls a "Marketsafe CD". This product really is not a CD, but rather is an inappropriate investment for most.

I have written in the past about EverBank’s practice of offering so-called “Marketsafe CDs” which are designed to give depositors the opportunity to earn above-CD rate returns tied to certain currencies or interest rate fluctuations.  EverBank claims that the Marketsafe products, unlike those that it marketed a decade ago, do not involve a risk to principal if held to maturity and therefore these products can be marketed as CDs.   The CD designation, however, remains dubious as EverBank reserves the right to return less (presumably much less) than the principal amount not only should you need the cash back earlier, but also upon death or adjudicated incompetence.  Also dubious is EverBank’s right to offer these “Marketsafe CDs” with just an unclear termsheet instead of an offering memorandum filed with the SEC as is required by the Securities Act of 1933.

The description of the currently offered 3 Year Marketsafe BRICS CD reads a lot like a classified for a used car:

If you believe that good things are on the horizon for the major emerging market economies of Brazil, Russia, India, China and South Africa (aka the BRICS nations), this could be the opportunity you’ve been waiting for. With our all new MarketSafe BRICS CD, we’ve united the currency indices of all five nations into one bold financial opportunity. Available now through October 15, 2014, it’s your chance to seek the upside of the indices without any risk to your deposited principal. And with no cap on their upside potential, the results could be strong. Remember, as economies emerge, so too does opportunity.  (https://www.everbank.com/investing/marketsafe/brics?cm_sp=marquee-_-1-_-marketsafeBrics)

The termsheet provides a little more color.  It states that the product pays no regular interest for the three year period, but upon maturity delivers a single payment of your principal plus any appreciation of the basket of Russian, Indian, Chinese, Brazilian and South African currencies.   While neither EverBank nor the depositor hold the basket, the exchange rates are observed bi-annually and the level of appreciation is calculated based on those measurements and a 20% allocation to each.

There are underlying realities that anyone investing in this product would need to be keen to ignore.  First, in spite of what EverBank says on its website, the so-called emergence of these economies does not necessarily translate to currency appreciation versus the US dollar.  The Russian ruble, the Indian rupee, the South African rand and the Brazilian real have all depreciated against the US dollar over the last 3 years (only the Chinese renmenbi has appreciated).  As someone who has done business in all five of these countries and observed the outflow of money gained from commodities there into real estate in North America and Europe, I can assure you that even if one or two of these currencies appreciates against the US dollar over the next three year, the entire basket will not.  This is especially true given that the prospects for the US dollar to appreciate globally are so strong as US interest rates begin to increase over the next three years.

Second, due to the measurement dates in EverBank’s instrument, the basket relies on steady and balanced appreciation versus the US dollar (decline in the US dollar) for the depositor to wind up with any appreciation in their so-called CD after three years.  Each of these currencies is so inherently volatile that steady appreciation just is not going to happen in any one of the currencies, much less the basket.

Third, your money is not worth nothing over three years.   The best three year online CD rate is currently 1.50%.  $200,000 invested in a CD at that rate over will produce $9,136 in interest (exclusive of tax consequences) over that time.   Since EverBank’s Marketsafe BRICS CD relies on a steady appreciation of the five BRICS currencies versus the US dollar and does not benefit from compounding of interest, you will need to see not just a steady increase in the basket (decline in the US dollar) versus the basket, but a steady decline that amounts to close to 2% a year just to match the return on a CD.

See the best 3 year CDs here.

A product that has none of the features or appreciation of a CD, but instead has a very high likelihood of returning only your principal is not a CD, but an interest-free loan to bank, and a bad investment.    Those seeking straight exposure to emerging markets can invest in a US dollar denominated emerging market bond fund (either sovereign or corporate), and those believing that a fall in the dollar versus emerging market currencies is imminent can invest one that is not US dollar denominated.   Investors can also look at registered offerings issued from time to time by Morgan Stanley and other investment banks that are designed to return up to 11% annually if a single currency, such as the Brazilian real, appreciates against the US dollar, and still returns 1% annually if they depreciate.  

Intermediate Term CDs Have Become Significantly More Compelling than Even the Highest Quality Municipal Bonds

Intermediate Term CDs Have Become Significantly More Compelling than Even the Highest Quality Municipal Bonds

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Historically, the wealthy and near wealthy have been prompted by brokerages like Morgan Stanley and Merrill Lynch to eschew CDs in favor of high grade municipal bonds. While the advice of the major brokerages has a self-serving function (they generate commissions on their clients’ municipal bond trades, but lose assets under management when a client withdraws cash to purchase a CD), it has also been very sound advice. The competitive market in CDs and rapid decline in long term interest rates has now made intermediate term CDs much more attractive.

As a general proposition, an investor who has carved out a sum of cash (say, $200,000) that they have relative certainty that they will not need for an extended length of time and do not want to risk, would give careful consideration to putting the money into a municipal bond.   Buying a long-term municipal bond that is triple tax-free produces interest that can be especially valuable for those in higher income brackets.  So long as the investor purchases only high grade municipal bonds insured by Berkshire Hathaway, the biggest risk to a municipal bond purchase is that interest rates rise and the value of the bond declines.  Most municipal bond purchasers get comfortable with interest rate risk by accepting the notion that if rates rise, they will just hold the bonds to maturity.   While purchasers today may get comfortable with the notion, they also need to recognize that municipal bonds ordinarily trade according to 10 year bonds rates.  With those rates running around 2.40% and Bloomberg’s 10 year municipal bond index running at 2.20%, municipal purchasers in high tax states like New York, Massachusetts, Illinois or California are unlikely to find high quality 10 year munis yielding over 2% to maturity.

This same investor now has the option of putting the money in a 5 year CD.  While the CD does not have the same tax benefit (interest is taxable local and federally in the year of accrual), the rates are slightly higher (the best 5 year CD rate is now 2.30%) and capital invested in a CD is not at risk up to FDIC limits.  Most importantly, the interest rate risk is simply much lower than that inherent in buying municipals with 10 year interest rates at such low levels. 

This chart demonstrates the spread between the 10 year Treasury rate and the best available 5 year CD rates over the last five years.  With the rates crossing for first time in a year, and for the first time since higher rates became a real prospect in the US's immediate future, CDs look attractive.


There are at least three reasons why the interest rate risk in the intermediate term CD may always be lower which are especially relevant in the current environment with the prospect of higher rates.  They are as follows:

1. A five year CD has a five year interest rate risk.  If you apply the same notion that the works case scenario is that you hold to maturity if rates rise,  a five year CD is always going to have a much shorter time horizon to getting your principal back than a 10 year municipal bond.

2. Most CDs allow breakage and a return of your principal with certain penalties.  The penalties for breaking a 5 year CD among the major issuers of online CDs range from 6 months to 15 months of interest.  If, for example, the US were to return to normalized interest rates in 2015 or 2016, you can pay the penalty and get your principal back.   The municipal bond doesn’t have breakage provisions and you would be faced with a huge loss of principal if you were to need to sell.  Tip: Always check the breakage penalty before you buy a CD.

3. Some online CDs allow for the penalty-free breakage of a CD upon the death of a holder at the request of the heirs, beneficiaries or executor (you may wish to ask before opening an account).   If you were to die holding a municipal bond at your death, the executor or executrix of your estate may need to liquidate the bond and the value will depend on interest rates on that day and the liquidity of the bonds.   Again, if interest rates were to return to their pre-2008 levels, your estate will recover significantly less than the price you paid for the municipal bonds.

Even if you don’t plan to need your money, life throws curves.   Municipal bonds bear interest rate risk.  With municipal rates at very low levels, you may be better off handling the interest rate risk by buying a 5 year CD.

See the best 5 year CD rate here.