Risk Considerations Risk Considerations   

Selecting the Right Type of CD

Investors commonly allocate a portion of their portfolio to Certificates of Deposit (CDs), which are covered by the Federal Deposit Insurance Corporation (FDIC) up to applicable limits. However, it can be confusing to determine which type of CD is best suited to a particular requirement. Due to the variety of needs among fixed income investors, a range of CD options are available which address most common scenarios. The following information may help investors select the appropriate CD for their investment goals, whether it be Callable or non-Callable, Zero Coupon, Fixed-Rate, Step-Up or a Market Index Linked CD.

Callable vs Non-Callable

The first decision which must be considered is whether to choose a 'Callable' CD or non-Callable CD. This is referred to as "call risk". In the case of a Callable CD, only the issuer has the right to 'call' (pay off) the issue early. Obviously, CDs which are not callable are the simplest, since they allow the holder to know precisely how long the CD will be held and how much interest will be received. If an investor requires to receive funds at maturity, even at the sacrifice of higher rates of interest available from Callable CDs, then a non-Callable CD (often called a 'bullet') may be the answer depending upon their investment profile.

Non-Callables (Bullets)

The term 'coupon' refers to an interest payment. Many investors require consistent cash flow, possibly to fund expenditures of some nature. As a result, they demand the regular coupon payments offered by Fixed-Rate CDs. These CDs are issued at a price of 'par', which is the principal amount to be received at maturity. Subject to the solvency of the issuer and applicable FDIC insurance limits, interest coupons are paid either monthly or semi-annually over the life of the CD, each based on the same fixed level set at issuance (in accordance with prevailing interest rates). The particular pattern of cash flow required by the investor may determine preference between monthly or semi-annual interest payments. Note that semi-annual pay CDs generally offer a higher interest rate than monthly pay CDs.

Certificates of Deposit: Inflation-Protected

Inflation-Protected CDs (CDIPs) are an investment alternative created to assist in offsetting the effects of inflation. CDIPs are similar to U.S. Treasury Inflation-Protected Securities (TIPS), where the principal amount is adjusted periodically to reflect changes in inflation. CDIPs pay a stated fixed rate of interest like a traditional CD, however interest is paid semi-annually on an inflation-adjusted base amount, not the original investment amount. At maturity, additional interest is paid equal to the total increase (if any) of the inflation-adjusted base over the original investment. Thus, both the final payment at maturity and the periodic interest payments increase as inflation rises.

Market-Linked or Structured CDs

For capital which can be targeted toward the potential of higher return on investment in exchange for market risk and risk of loss, market-linked CDs provide investors with the opportunity to participate in equity or other markets while protecting their original investment up to applicable limits. These structured CDs typically earn no interest prior to maturity, at which time interest is paid based on the performance of a specified market index. For example, an equities-linked CD may be based on the appreciation and potential depreciation of a broad-based index such as the S&P 500®. Note that principal is repaid at maturity, regardless of index performance. Investors in structured CDs must evaluate the outlook for the underlying index, and should intend to hold the CDs until maturity.

Estate Feature

A standard feature available on most CDs offered through broker dealers, frequently referred to as a 'survivor's option 'or 'death put', provides for optional redemption in the unfortunate event of death or legal incompetence of the owner. In this circumstance, the estate may redeem the CD at par (or in the case of a Zero Coupon, at accreted value based on original issue yield).