A callable certificate of deposit gives the bank the right to terminate the deposit, after an initial noncallable period prior to the stated maturity of the CD. When yields are trending lower, it gives the bank an out so it can replace the called CD with a new one at a lower CD rate. It's just like consumers deciding to refinance their mortgage when interest rates head lower. In the case of banks, they refinance their deposits.
Investors like callable CDs because they earn a higher yield on a callable CD than they would for a noncallable CD. The financial institution has to offer the investor a reason to invest in the callable CD, and the pickup in yield is that reason.
When CD rates are trending lower, callable CDs tend to be a lousy deal for depositors because, while they get the yield pickup, if the CD is called they have to reinvest in a lower yield environment. When yields are trending lower, CD investors want to be locked into long-term deposits.
When yields jump
But what about when yields are trending higher? The bad news is that the financial institutions are using sophisticated option pricing models to determine how much of a yield pickup they'll offer for a callable CD, and that yield pickup should narrow since it is less likely that the CDs will be called, and the banks don't want to pay above-market yields on a callable CD that they don't expect to call.
So why should investors look at callable CDs in a rising-yield environment? While the yield pickup should be less than in a downward trending yield environment, the investor can still get an above-market yield when compared to noncallable CDs. A CD investor building a laddered portfolio, or even a barbell portfolio like I discussed in last week's blog, can get an incremental advantage by considering callable CDs.
What the CD investor would truly want in a rising-yield environment is a putable CD, where the CD could be put back to the bank if rates were to head higher. In that case, the put option would cause the CD yield for the putable CD to be below market yields because of the value of the put option to the CD investor. (This structure is not commonly available in the U.S. for retail investors.)
As I write this, Bankrate's highest yielding noncallable five-year CD has an annual percentage yield of 2.01 percent. My questions to you are:
How much of a yield pickup would you want from a callable CD with a five-year maturity and an initial six-month period where the CD couldn't be called away from the depositor?
How much of a yield "haircut" would you be willing to accept for a putable CD with a five-year maturity and an initial six-month period where the CD couldn't be put back to the bank?
Is a callable CD a viable option for you, should interest rates rise?
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Don Taylor is Bankrate's Personal Finance Adviser and an assistant professor of business administration at Penn State Brandywine in Media, Pa. He holds a doctorate in finance and has earned both master's and bachelor's degrees in finance. To ask a question of Dr. Don, go to the "Ask the Experts" page and select select one of these topics: "Financing a home," "Saving & Investing" or "Money."