What's old is new again, as certificates of deposit are becoming an increasingly attractive investment vehicle.
Pay close attention to tonight's entertainment report. Between the updates on Paris Hilton's new party dress and Leo DiCaprio's latest environmental fundraiser, the certificate of deposit (CD) might earn some airtime for being the hot new story of the investment world.
Inflationary concerns affect rate outlook
Recent economic trends have prompted banks to raise rates on long-term CDs, giving income-oriented investors another option for their cash. These trends include a languishing U.S. dollar, and ever-decreasing interest rates-two factors that often precede periods of inflation. When inflation rears its ugly head, the Fed typically responds by raising rates to rein in the money supply, and hold down price increases.
This prospect of higher future rates is the primary driver for rising long-term CD rates. Issuers are encouraging investors to lock in funds now at rates that are attractive by today's standards. This protects the banks from having to pay the higher future rates if they materialize. For that reason, some institutions are offering rates in excess of 4.5 percent on five-year deposits. Compare the annual percentage yields offered by Discover Bank as of May 6, 2008: 3.51 percent on a one-year CD, and 4.6 percent on a five-year CD. The difference between the two rates shows just how much Discover is willing to reward investors for locking in longer maturities.
Given all the rate uncertainty, banks are likely to start pushing callable CDs. These are time deposits that the bank can cash out prior to maturity, usually after a year. If rates don't pick up as expected, the bank will redeem the CD early, and leave the investor to find another income-generating vehicle. But if rates do jump, the investor will be locked in until maturity.
Smart investment choices
Investors considering CDs should weigh the pros and cons. Locking in deposits now guarantees the yield for the next five years. But if rates are indeed driven higher, that yield may end up being weak relative to what's available on the market. There's also the chance that inflationary concerns won't pan out, and rates won't rise dramatically. In that case, the investor wins out.
These moving pieces force investors to choose what's more important: locking in a minimum rate now, or ensuring maximum yield in the future. When investors are concerned about maintaining a minimum level of interest income for the intermediate term, they shouldn't shy away from locking in a five-year CD. But those concerned about the loss of liquidity, and the potential to miss out on higher future rates, might be better off holding back.
Even if you don't see a CD feature on tonight's entertainment report, it's still a worthy investment to consider. At least you know that your principal value won't go down-which isn't the case with other types of investments.