 Does
CD ladder make sense these days?
|
 Dear
Dr. Don,
An older friend suggested that once I get settled, I start
putting some emergency money into a CD ladder.
Looking at the
APYs for high yield savings accounts/MMAs, such as from ING Direct and GMAC, it
seems that they are only marginally less than the best available CD rates. Any
benefit offered by the increased rate seems voided by the loss of liquidity. Is
there any advantage to putting money into CDs in today's economy?
-- Ken
Conundrum
 Dear
Ken,
Establishing an emergency fund makes sense as a first step in
building financial security. How big the fund should be depends on factors like
your job security, how you're paid for your work and your net worth. A rough rule
of thumb is to set aside three to six months worth of living expenses in liquid
or near liquid funds. A Bankrate feature, "Building
an emergency fund," explains emergency funds in greater depth.
One
problem with keeping the money in liquid funds is that typically short-term yields
are less than the yield on longer-term investments. You wind up paying a liquidity
premium in the form of lower returns on your emergency fund investments. Ideally,
you'll never need the money in the emergency fund so you continue to pay that
premium over the years.
A CD ladder is one way to finesse that trade-off. One
problem in using a CD ladder to invest your emergency savings is
that you'll pay an early withdrawal penalty if you have to cash
in CDs before they mature. Another problem in the current market
environment is the one you mention in your letter, namely you're
not picking up much, if any, yield by investing in longer-term CDs. That's
because the yield curve, at least for U.S. Treasury securities,
is inverted. The yield curve for CDs is more flat than inverted.
A yield curve is a graph of the
relationship between interest rates and time to maturity for a particular risk
class of debt security. The Treasury yield curve and a CD curve based on Bankrate's
100 Highest Yields are shown below:
 |
Yield curves |
|
| |
|
With the CD yield curve as flat as it is, it would
seem to be an easy decision to stay short and invest your emergency
savings in money market accounts or money market mutual funds earning
north of 5 percent annual percentage yield, or APY.
The problem with that decision is that you don't really
know where interest rates are headed. There's a general consensus
that the Federal Reserve is about done for this interest rate cycle
in raising the targeted federal funds rate. If that's true,
future rate cuts will bring about lower money market rates. The
effect of future rate cuts on longer-term CDs isn't as easy to predict.
The
idea behind a CD ladder is to get you past trying to time the market. You
invest across maturities and as the nearby CD matures you use the proceeds to
buy a new CD at the longest maturity. The Bankrate feature, "How
to ladder a CD portfolio," has more on building a laddered CD portfolio.
If you like the short end of the curve, build a step
ladder instead of an extension ladder and roll into longer maturities
when you like how they look. Keep your finger on the pulse of CD
rates by getting the CD
Rate Trend Index delivered to you every Wednesday as an e-mail
or read it on Bankrate.
To ask a question of Dr. Don, go to the "Ask
the Experts" page and select one of these topics: "financing
a home," "saving & investing" or "money."
| 
