Are callable CDs a risky investment?

Don TaylorQuestionDear Dr. Don,
I was offered a callable CD, 10 years at 7.25 percent. After one year the rate changes, based on some formula that uses the yield on a Treasury note. The broker said, however, that it will be called in one year. Is this safe or a risk?
-- Joan Jump-start

AnswerDear Joan,
A good rule of thumb is if you don't understand the investment, don't invest in it.

Callable CDs give the bank the ability to redeem your CD prior to its stated maturity. The bank would want to call the CD if interest rates headed lower. It would call your CD and borrow at the lower interest rate. When the CD is called, you have to find a new place to invest your money in a lower interest rate environment. To get you to invest in a callable CD, the financial institution offers a slightly higher yield than on a noncallable CD.

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So when you invest in a callable CD, you get a slight pickup in yield. If rates go lower, the CD is called away and you have to reinvest in a lower interest rate environment. If rates head higher, you're locked in to a CD with a lower yield than what's available in the current interest rate environment. It's a classic "heads I win, tails you lose" investment, with the banker calling the coin toss. The Securities and Exchange Commission publication, "High-Yield CDs -- Protect Your Money by Checking the Fine Print," provides additional background on callable CDs.

These CDs typically have an initial time period when they cannot be called. The noncall period for this CD is probably the one-year period mentioned by the broker. There's no guarantee that the CD will be called a year from now.

If it's a negotiable CD, the value will rise and fall in value with market conditions. If you want out before the CD is called or matures, you're likely to take a loss in selling it. That's true even if the deposit is insured by the Federal Deposit Insurance Corp.

From the rate you quoted, my guess is that this is a step-up CD. That means that the yield increases over time, in steps. It's unlikely that you'd earn a 7.25 percent yield in the first year and then have the CD called away from you.

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