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Barbells bump up CD rates

By Sheyna Steiner · Bankrate.com
Wednesday, October 13, 2010
Posted: 2 pm ET

CD rates are likely to stay low for some time. After the September meeting of the Federal Reserve Open Market Committee, the statement from Ben Bernanke spelled out the Fed's intention to leave rates low for an extended period of time and possibly drive rates even lower through a process called quantitative easing.

Quantitative easing is one of the tools available to the Fed to stimulate the economy. Basically they buy up government debt securities, putting cash into the economy.

What could be good news for the economy -- eventually -- is bad news for CD rates.

In light of the ongoing efforts by the Fed to keep interest rates very low, Bankrate's senior financial analyst, Greg McBride, suggests that a barbell strategy might be useful for an investor with a need for cash in 2 years. However, he suggests forgoing short-term CDs on one end of the barbell and sticking with cash for flexibility.

"Rather than investing in a one-year or two-year CD, a barbell investor might opt for half in liquid cash -- for emergencies, unplanned expenses and flexibility -- with the other half in a five-year CD, where the yield is more than enough to trump a shorter-term CD even after paying a typical early withdrawal penalty," he says.

Investors typically use barbell strategies to diversify their portfolio and increase yield. Investments on one end of the barbell are long-term CDs or bonds and on the other end are CDs or bonds that are very short-term.

In this case, investors who want their money in 2 years, whether because they anticipate a rate increase or need the money for any other purpose, would be better off going further out on the curve to 5 years rather than buying a two-year CD.

Let's look at the math using an even initial investment of $12,000.

$6,000 goes to cash or cash equivalent.

$6,000 is invested in a five-year CD with an annual percentage yield of 2.6 percent with a six-month early withdrawal penalty.

After 2 years your investment will have earned $316.

The six-month early withdrawal penalty equals $78.

Total earned: $238.

Compare that to:

$6,000 invested in a two-year CD with an APY of 1.7 percent.

 The total earned would be $206.

Use Bankrate's rate tables to find high-yield CDs across the country.

There are some caveats: investors must check the early withdrawal penalty. Some banks have less onerous penalties and some penalties are much more than 6 months' worth of interest.

Earlier this year, Bankrate surveyed banks to find out what kind of early withdrawal penalties are out there. Go here to get an idea of the range of penalties.

Also, McBride recommends that this strategy would work best in a tax-advantaged account and only with CDs, not bonds, due to the interest rate risk.

When else might a barbell strategy be appropriate?

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