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Managing expectations and CDs

By Dr. Don Taylor ·
Thursday, December 26, 2013
Posted: 9 am ET

Conventional wisdom has interest rates headed higher. Savers hate being long and wrong, meaning they locked in to a long-term investment only to see yields head higher. By the way, investors earn a yield, borrowers pay a rate. That's why certificates of deposit quote an annual percentage yield and mortgages have an annual percentage rate. To take it a step too far, APYs are required by the Truth In Savings Act, or TISA, while APRs are required by the Truth In Lending Act, or TILA. Activities under both acts are overseen by the Federal Reserve Board.

Savers are worried about rising rates so they stay in short-term maturities, waiting for rates to head higher. A laddered CD portfolio or even a barbell CD portfolio as discussed in my earlier blog posts can take CD investors away from trying to time the market. But the expectations theory of interest rates says, at least over the initial investment horizon, it doesn't really matter.

So, today I'm going to talk about expectations theory in CD investing. Expectations theory states that short-term CD yields are a function of long-term rates. Roughly speaking, that means that if a five-year CD is yielding 2 percent and a 2 1/2-year CD is yielding 1 percent, the 2 1/2-year rate, two and a half years from now, is expected to yield 3 percent. That would have the yield on two, 2 1/2-year CDs equal to the five-year CD yield. I say roughly speaking because an arithmetic average of yields is only an approximation since compound interest is a geometric function.

The point to all this is that if you buy in to expectations theory, you can feel better about keeping your money invested in short-term investments while waiting for CD rates to rise. It's a little solace in today's low interest rate environment, but solace nonetheless. Focusing on high-yield savings accounts versus short-term CDs should also mitigate the risk of staying short.

What do you think? Are you hanging out in short-term investments waiting for yields to rise or are you buying longer-term investments with the expectation that a series of short-term investments can't beat the longer-term yield?

Or, do you have a laddered CD or barbell CD portfolio?

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