With interest rates rising, bank certificates of deposit are surging ahead of bonds as the apple in investors’ eyes.
In March, after the Federal Reserve hiked interest rates by 0.25 percent, banks, especially online financial institutions, started to inch their CD rates up toward 3 percent. Compare that to terms as recent as 2015, when CD rates stood below 1 percent.
With CD rates on the rise, investment professionals say they’re seeing more long-term investors turning away from fixed-income instruments.
There are some good reasons to do so, financial expert say.
“With bank CDs, there is no interest rate risk. The value of direct CDs doesn’t fall when interest rates rise,” said Ken Tumin, banking expert at DepositAccounts.com. “Plus, there’s no credit risk as long as you remain under the FDIC/NCUA coverage limits, and CDs can also sometimes offer higher yields.”
Advisors and retirement-oriented clients should plan carefully with bank CDs, he added.
“CDs take more work to manage, especially when maximizing yield and they’re typically not an option for 401(k) plans.”
As bank CD demand rises, that makes bonds less attractive, other experts say.
“Turning to CDs for a guaranteed rate of return is tempting as yields are rising and correspondingly putting pressure on bond prices,” said Jennifer E. Myers, a financial planner and president of SageVest Wealth Management in McLean, Va.
Myers offered some “pros and cons” on the CDs versus bonds:
Certainty. CDs offer a certain return that's not subject to interest rate fluctuations, Myers said. “This is attractive in a rising interest rate environment in which bond investors have suffered recent investment losses as bond prices move inverse to interest rates,” she noted.
Income Source Guarantee. If you're a retiree who's dependent upon your income stream, having a known, guaranteed source from maturing CDs can be attractive, without risking bond value dilution, Myers added.
Low Yields. While CD rates have risen over the past year, they're still compressed and not that much higher than high-yield saving rates. “Hence, you have to ask yourself if it's worth tying up your investments in CDs for just a little extra yield potential,” Myers said.
Penalties. Penalties are a significant detractor of CDs as they limit your flexibility. “If your income needs might vary, or you might want flexibility to reposition your investments, CDs might not offer these options to due to penalties imposed when CDs are sold prior to maturity,” Myers added.
“If we enter a market downturn, and you want to buy stocks on a dip, are you going to be willing to pay a penalty to do so? If the answer is no, you could be poising yourself to forfeit a prime investment opportunity.”
Lost Return Potential. CD investors might avert bond loss potential if we move into a rising interest rate environment, Myers said.
“However, they also need to consider lost earnings potential, particularly considering we're in the mature phase of the second-longest bull market in history,” she noted. “We're due for a correction, and Treasuries typically rally as safe havens during market downturns.”
In that scenario, CD investors could be averting bond losses, however, when the stock markets correct, they could be forfeiting both a Treasury bond rally plus the ability to buy stocks at attractive prices, Myers explained.
Consider Unique Needs
When comparing CD’s to bonds, it really depends on an investor’s unique needs, advisors say.
“CDs are preferred because of FDIC protection,” said Eric Pomerantz, a financial advisor at Moody Investments in Austin, Texas. “Bonds tend to have higher rates and longer maturities. You can also benefit from capital gains on bonds as long as the yield curve remains positive.”
Brian O'Connell is a former Wall Street bond trader, and author of the best-selling books, The 401k Millionaire and CNBC's Guide to Creating Wealth. He's a regular contributor to major media business platforms. Brian may be contacted at [email protected]