Interest rates are at historical lows, and certificate of deposit rates are no exception. With years of paltry yields ahead, savers have fewer safe options than ever. The Federal Reserve has vowed to keep rates at their current ultralow level until mid-2015, which means savers will have to accept riskier investments or reduced income until then.
As the fifth year of the great yield drought launches, what can savers and CD lovers do?
Tip 1: Stick to short maturities
When rates are very low, fixed-income investors run into increased interest rate risk. If interest rates go up, savers are left holding underperforming investments to maturity or trying to sell them at a loss. While CD owners may be able to sell their CD, the more likely scenario would be to break the terms of the CD and take the early withdrawal penalty. That could wipe out years of interest or even eat into principal, depending on how punishing the penalty fee is.
To minimize interest rate risk, stick to CDs with shorter maturities rather than stretching for yield.
Tip 2: Beware of early withdrawal penalties
Early withdrawal penalties are all over the map and vary among financial institutions. Bankrate's 2012 early withdrawal penalty survey found that the fee for breaking a CD early can be as high as $25 plus 3 percent of principal at some banks. Most are not that onerous -- the average penalty for early withdrawal on a long-term CD equals six months' worth of interest. For CDs with a maturity of less than a year, the average penalty is equal to three months' worth of interest.
Read the fine print before buying a CD; bailing out early could take a bite out of your savings.
Tip 3: Save more
With a finite supply of money, individuals may struggle to supplement returns on their own. Some CDs, known as add-on CDs, allow you to add deposits, which could at least allow your initial savings to keep up with inflation.
Tip 4: Evaluate alternatives such as the bump-up CD
Some types of CDs are better suited to today's low-rate environment than others -- for instance, the bump-up.
If interest rates go up, a bump-up CD allows the owner to request a CD rate increase. With interest rates set to rise in 2015, longer term bump-up CDs would seem to be just the ticket for savers worried about chasing yield and interest rate risk. Unfortunately, they may be hard to come by.
"In traditional banking products, you have trouble finding products longer than two years," says Jeff Currie, a financial adviser with Icon Financial Services in Boise, Idaho. "But in the credit union world, you can find the 60-month maturity. And savers probably will have the option to move up within five years."
Rates on bump-up CDs are typically competitive with regular CDs but are less than a special promotional rate.
"Another norm is that they usually have higher deposit limits. Instead of $500, it's $5,000," Currie says.
Tip 5: Consider the indexed or structured CD
Another nontraditional CD is the structured CD, which is linked to some other kind of investment, such as the stock market, currency market or commodities. Though they won't lose money as long as they are held to maturity, returns are typically capped at a percentage of the total return of the underlying index or basket of securities.
For example, if it's linked to the Standard & Poor's 500 index , and that index returns 10 percent in 2013, a structured CD may yield three-quarters of that. However, it varies among products. That is one of the criticisms of structured CDs: They can be very complex compared to a conventional CD.
But the potential for greater returns pulls in savers, according to Currie. There are more downsides though, the most visible of which can be the statement showing the value of the investment sinking from year to year.
"You can lose money if you sell it early, and you will lose money on the statement almost guaranteed. There will be a value less than you've put in. I've never seen one that didn't depreciate," says Currie.
The drop in value isn't necessarily a result of volatility in the underlying investments, but due to the limited demand for these types of CDs on the secondary market.
"The secondary market is so illiquid that the price that is stated is not a true representation of the potential to get the face value back at the end of the term, which is guaranteed," Currie says.
Tip 6: Try a (short) ladder
Savers can mitigate interest rate risk, take advantage of higher yields on longer maturities and increase liquidity by splitting savings among CDs of varying maturities. One way of doing that is with a CD ladder.
With an initial investment of $10,000 and a maximum maturity of five years, a saver would divvy her money among a one-year, two-year, three-year, four-year and a five-year CD.
As the one-year CD comes due, the proceeds are recycled back into the ladder with the purchase of another five-year CD. Because there's still a long window of time before the first rate increase by the Fed, it may make more sense to start with a shorter ladder and then extend it after rates go up.
Tip 7: Consider a barbell strategy
A barbell is another CD investing strategy. It's very similar to a ladder, but the middle rungs are missing. Short maturities make up one end of the barbell, or investors may even put money in a high-yield savings account to keep part of the principal more liquid. Long-term maturities comprise the other end of the barbell.
Tip 8: Shop around
Online banks and credit unions may offer higher yields than traditional banks. Local banks may offer higher yields than national banks, and any type of financial institution may run CD specials based on their own cash needs. That's why it will pay to shop around. Use Bankrate's CD rate tables to get an idea of what's out there.
Tip 9: Take care when stretching for yield
One of the aims of the Fed's monetary policy since the financial crisis has been to push savers and investors into riskier investments. As a result, people who want, or need, higher yields may take on more risk than they can afford.
Investors who need to preserve principal to live must be careful about the types of investments they buy to meet income needs. Dividend stocks, bonds and structured notes have become de facto CD alternatives as a result of very low interest rates, but they are far from CD equivalents. The risk to principal can be very high.
There is no free lunch; if it seems too good to be true, it probably is.
Tip 10: Consider higher-risk investments
If you are comfortable taking some risk with principal, it could pay to venture out of the CD realm and into those bonds, structured notes or dividend stocks that we just warned you about. After all, leaving your money in CDs is also risky -- you may not lose principal, but you will lose purchasing power if inflation exceeds the yield you're getting, which it most assuredly will. Allocating 10 percent or 20 percent of your portfolio to other fixed-income investments can help you achieve the yield you're looking for.
Investments become more risky as the potential for greater returns rises. Highly rated corporate bonds carry interest rate risk, as do all fixed-income investments, but relatively little credit risk, or the chance that the issuer will become insolvent. High-yield bonds may offer more return but include the possibility that the issuer will go bankrupt. The value of stocks can rise and fall with the market, completely unrelated to the fundamental value of an individual company's share price.
The type of securities you buy -- and the proportions in which they are purchased -- should match your risk tolerance and time horizon. Stretching for yield isn't always bad -- as long as savers understand the upsides and downsides of any potential investments.
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