What is a callable CD?
A callable CD is a certificate of deposit that can
be called away from the investor after the call-protection period
has expired, but before the CD matures. A five-year CD with a six-month
call protection would be callable after the first six months.
Banks offer callable CDs to shift interest-rate risk
to the depositor. Because the depositor is taking on this interest-rate
risk, a callable CD will have a higher yield than the same maturity
CD without a call provision. The additional yield is partial compensation
for the depositor accepting the interest-rate risk.
Interest-rate risk is the risk
that interest rates move against you during the period that you
hold the investment.
For the bank, interest-rate risk means the risk that
interest rates go lower and by waiting they could have issued CDs
rates at lower rates. For the depositor, it means that interest rates go
higher and by waiting they could have bought CDs at higher rates.
Neither side wants to be long and wrong -- that is, to commit to lending
(borrowing) long-term as interest rates trend higher (lower).
Banks are managing their interest-rate exposure by
selling callable certificates of deposit. They employ complex option pricing models
to determine how much they are willing to pay the depositor to purchase
a callable CD versus a non-callable CD. They do the analysis because
they are managing the interest-rate exposure of their loan portfolio
against the interest-rate exposure on their deposits.
The bank is hedging their interest-rate risk. It's
the depositor who is speculating with a callable CD. The typical
investor just eyeballs the difference in the two rates and decides
whether it's worth their while to invest in a callable CD.
Here's what is undesirable about consumers
buying callable CDs: If interest rates go lower, the CD gets called
away and the investor has to reinvest in a lower interest rate environment.