CD investing: Safety trumps yield

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Dear Dr. Don,
I have about $115,000 to invest. I can get a yield of 3 percent from a five-year certificate of deposit. Do you think I should do it, or is the maturity too long? I would like your opinion. I think CD laddering stinks at current rates. It would give me a yield a lot lower than 3 percent.
— Robert Rung-out

Dear Robert,
Laddering does stink at current rates. What tempers the smell is the ability to reinvest in the market in a systematic way over time as the rungs mature. If you buy a five-year CD, you take the risk that you are “long and wrong,” locking into a five-year investment in a rising-yield environment. That’s the crux of your question: “Is the maturity too long?” I can’t provide you with a definitive answer to that, but if you don’t go past that five-year maturity, meaning you’re not CD laddering, it’s unlikely that a series of short-term CD reinvestments out to that date will beat your five-year yield.

What is your true investment horizon? This typically springs from the goals you have for the investment. What do you want the investment of this money to accomplish? Are you an income-oriented investor who needs current income? Or, are you trying to build wealth to finance a future financial goal? Or, is the safety of principal paramount?

For CD investors, safety of principal typically trumps building wealth as an investment goal. They’re willing to earn a reduced yield for the knowledge that they can’t lose money in the investment. However, there’s another risk, and that’s purchasing-power risk. If the yield on your CD isn’t higher than the inflation rate, your deposit loses purchasing power over time.

There are investments that guarantee principal and inflation-indexed returns — Series I savings bonds and Treasury inflation-protected securities, or TIPS. Newly purchased Series I savings bonds just earn the inflation rate, annualized at 4.6 percent at the time of writing, but the Treasury limits the amount you can purchase to $5,000 in paper form and $5,000 electronically in a calendar year. Five-year TIPS were priced to yield the inflation rate less 0.84 percent at the time of writing, so that’s not the answer. TIPS with longer maturities offer a yield over and above the inflation rate, but there’s price risk if you have to sell before they mature. Also, the yield above the inflation component looks a little stingy and for most investors, they’re best held in tax-advantaged retirement accounts.

Where’s all this leave us? Stay happy with your five-year CD if that matches your investment horizon and investment goals. Start looking around for investment alternatives if increasing your purchasing power or building wealth are motivating factors to consider alongside the safety of principal.

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