Callable CD Rates

Callable certificates of deposit (callable CDs) are a derivative of the very much standard certificate of deposit. While they are fundamentally the same type of investment vehicle, there is one very minor difference that makes a callable CD very much different from traditional investment options.

The callable CD is one in which the issuing bank has the option to call the CD, just like a callable bond comes with the option for the bond issuer to call the bond. This call option means that at any time (as defined by the contractual agreement) the issuing party can pay you, the CD investor, an amount equal to your principal plus accrued interest and close out the investment.

There are a number of reasons a bank may choose to call a CD

  • Interest rates are falling – Falling interest rates mean that a bank can afford to borrow money from a different source to pay you back. In doing so, the bank locks in the current interest rate and avoids paying you a higher than average market rate for your money. Of course, this isn’t so beneficial for the investor, who would now have to seek another investment alternative in a low-interest environment. If a CD gets called, it is likely that the call was made because rates have fallen, and finding another investment with yields equal to the previously owned CD may be difficult.
  • Restructuring liabilities – Occasionally, banks choose to call CDs when they see limited uses for borrowed funds. Alternatively, they may seek to close out exposure to CDs and call CDs in an effort to reduce costs. As the cost of banking rises, keeping so many customer accounts active can prove to be costly, especially if these accounts hold very small amounts of money

Callable CDs are merely an option for investors, and do not have to be purchased. While most investors prefer to buy traditional CDs because they can forecast cash flow into the future (the CDs cannot be called once purchased), some investors like to buy callable CDs because the risk of falling interest rates is not priced into the yield; thus, callable CDs often provide for higher rates of interest as the bank does not risk exposure to falling interest rates, and because the bank has to make attractive the idea that the CD can be recalled.

What Investors Need to Know about Callable CDs
There are two very important pieces of information that everyone should know about their callable CDs, and those are the call date, as well as the maturity date.

The call date is the length of time in between call options, or how long a bank must wait before it can decide to call the CD, and close the account. If, for example, you purchase a CD with a 6-month call date, the bank has the right to consider calling back the CD every six months until maturity.

The maturity date is the length of time you wish to purchase a CD. The longer the time horizon, the higher the yield, so when an investor wants to get the most bang for his or her buck, it would seem that the best way to make the most money is to buy a CD for a very long-dated maturity. Because the bank can recall these CDs, callable CDs are often sold with maturity dates for much longer periods than are other CDs. A traditional CD usually caps at 5 years, while banks have been known to issue callable CDs with maturity dates as spread out as US Treasuries: 20 years or more.

The Case Against Callable CDs
Many investors are roped into buying callable CDs because they see opportunity for earning higher interest rates in low-rate environments. While this is attractive, there is also a case to be made against callable CDs.

Remember that a callable CD is usually callable only by the bank, so if rates were to rise higher than the rate you locked in, you cannot call the CD in the way a bank can. Generally, investors who want to call their own CD investments would have to pay an early withdrawal penalty of up to 10% of their investment. This, obviously, is not a desired outcome.

The bank, however, can call a CD at any time, thus allowing the bank the advantage to get out of a bad investment where the investor does not have the same opportunity. Whether or not this is a necessarily bad trade is unknown, several studies have concluded that investors would have done equally well in traditional and callable CD strategies pending they used effective systems such as a CD ladder to protect their cash flow receipts.

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