Bond ladders are a popular vehicle for investors, like retirees, who want a guaranteed income available over time and are willing to hold the bonds until maturity, but at current interest rates a CD ladder makes more sense.
The CD yield curve, unlike the Treasury yield curve, slopes upward, which means that longer maturities have higher yields. Among Treasuries, three- and six-month bills and the one-year note are yielding more than two- and five-year notes because the curve has inverted at the front end after being flat for a period of time.
Meanwhile, the highest yielding 1-, 2-, 3-, 4- and 5-year certificates of deposit have an annual percentage yield that tops the 10-year Treasury yield and is almost equal to the yield of AAA-rated corporate bonds, which carry more credit risk. (The CDs are FDIC insured for accounts of up to $250,000.)
“It’s the best time in a decade to do this,” says Chris Horymski, senior research analyst at MagnifyMoney, a subsidiary of LendingTree.com, referring to CD ladders. “Rates [for CDs] weren’t budging until the past 12 months, when coincidentally, the Treasury yield curve started to flatten.”
And if the Fed’s next move is a rate cut, which is the market’s expectation, then 3% or 3.1% for a five-year CD will likely represent the peak in rates, which investors could lock in with a CD ladder now, says Horymski.
Horymski says the most common CD ladders consist of five rungs, one for each year between one and five years. After the first year, the one-year CD matures, each rung moves down the ladder by a year and the investor buys a new five-year CD to keep the full ladder intact or can invest in something else entirely.
There are two major types of CDs — bank CDs and brokered CDs. Among bank CDs, the highest rates are usually available from credit unions and internet banks.
Brokered CDs can be either new issues from banks or CDs trading on the secondary market. The latter CDs used to pay higher rates than bank CDs, but that’s no longer the case, according to rates data at DepositAccounts, another LendingTree subsidiary.
Investors who purchase brokered CDs will also have to pay a commission, and if they cash out before the CD matures they run the risk of losing money if rates rise.
Getting out of a bank CD may also cost investors, due to early withdrawal penalties. Allan Roth, founder of Wealth Logic, an hourly-based investment advisory and financial planning firm, recommends that investors check the early withdrawal penalties when buying a bank CD, noting that penalties of six months or less of forfeited interest are generally acceptable.
— Related on ThinkAdvisor:
- How to Invest With an Inverted Yield Curve
- Larry Swedroe: Risk Warrior in Action
- Consumers at High Risk for Dementia Put More Wealth in CDs: Researchers