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On their face, CDs may seem appealing. CDs – and especially brokered CDs, have still carried relatively attractive rates since the last series of interest rate hikes. In addition, a CD is protected by the FDIC’s deposit insurance, which provides $250,000 of coverage per depositor, per bank and per deposit type. This protection makes bank and traditional CDs seem like safe investments during market volatility.

It may make sense to put a portion of your cash reserves into CDs, especially if you're looking for a higher annual percentage yield compared to a regular savings account or money market account. However, CDs can have serious drawbacks. For example, putting your cash in a CD in lieu of your retirement portfolio can put your retirement goals at risk if you need a certain return to meet your goals.

Also consider liquidity. Your cash is typically locked in for six months or more when you invest in a CD, depending on the CD term, so you may face penalties or lose interest if you need to access your funds early. This may be problematic if unexpected expenses arise or other investment opportunities present themselves that could offer a higher return. Consider the factors below and consult with your financial planner before investing in this savings vehicle.

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INVESTING IN A CD VS A DIVERSIFIED PORTFOLIO

These days, some one-year CDs are sporting 5% annual percentage yields or more, making CD investing seem attractive for those seeking a higher interest rate. But after one year, when the CD matures, you need to reinvest that money and who’s to say available yields won’t be below 5%? Interest rates can fluctuate and future CD rates might not be as favorable. At that point, it’s possible your return would have been higher if you had invested the cash in the stock market or a diversified portfolio of stocks and bonds.

The average yield of one-year CDs was around 1% or below between 2009 and 2022, and the rates are showing signs of trending back in that direction. Such low CD interest rates during that period made CDs less attractive compared to other investment options like mutual funds or dividend-paying stocks.

Let’s say we use Treasury securities with one-year constant maturity as a proxy for one-year CDs since both are considered low-risk investments. Treasury bonds and CDs often compete for investors seeking safety with some yield. The yield of Treasury securities with one-year constant maturity has been highly correlated with the Bankrate.com US 1-Year CD High-Yield Rate Index over time. This correlation between Treasury bonds and CD rates shows how interest rate movements impact both investment options similarly. However, unlike CDs, Treasury bonds can be sold on the secondary market if you need liquidity before maturity.

Then, let’s compare the return of the one-year CD proxy from 1959 through 2023 to the performance of a group of securities representing 60% stocks and 40% bonds¹ – a traditional diversified portfolio. The 60/40 mix outperforms the proxy for the one-year CD. The diversified portfolio also outperforms inflation, helping to preserve purchasing power over time, but the CD proxy does so much less effectively. This highlights the potential higher yield and higher return associated with investing in stocks and bonds compared to CDs.

Although past performance will not guarantee future results, we believe a diversified mix of securities – including stocks, bonds, mutual funds or dividend-paying stocks – is better suited to help deliver the returns needed to achieve long-term financial goals, like a comfortable retirement. This strategy takes advantage of a basic principle of investing: higher risk can provide higher return. We should note that there is also a potential for losses in the short term for any diversified portfolio, so seeking these higher returns requires patience and a long-term investing horizon.

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TAXES AND INFLATION CURB CD INCOME

Something else to keep in mind: CD income is taxed at the ordinary income rate, unlike qualified dividends from dividend-paying stocks or long-term capital gains from mutual funds, which may have more favorable tax treatment. Any taxes chip away at your CD’s income. Also, depending on your tax bracket, the tax you pay on the CD’s income could be a higher rate than the long-term capital gains tax you may have had to pay if you sold investments in your taxable portfolio to fund the CD. For example, if you are in a higher tax bracket, the after-tax return on your CD investment may be significantly lower, reducing the effective annual percentage yield.

Inflation also chips away at a CD’s income. If inflation is running above 3%, that makes the 5% yield less impressive, especially when compared to potential gains from investments designed to outpace inflation, such as stocks or bond funds.

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WILL YOU MISS OPPORTUNITIES?

Standard terms for certificates of deposit are between three months (short-term CDs) and five years (long-term CDs). But during the CD term, you are not able to access this cash without facing penalties. This lack of liquidity could cause you to miss out on other investment opportunities that may arise, such as favorable market conditions in stocks or bonds. Always understand the rate you’re getting versus other opportunities and the CD’s investment terms, including whether the CD is callable or non-callable. Callable CDs can be redeemed by the issuer before the maturity date, which can affect your expected returns.

If you took money out of your stock allocation and placed it in a CD, then during the CD’s term, that cash will not experience the stock allocation’s returns, which may have outpaced those of the CD. Over time, the opportunity cost of not being invested in higher-yielding assets like stocks or mutual funds could be significant. Ultimately, the move into a CD may put you behind in your long-term goals, not ahead. This is especially true if your investment strategy aims for growth to meet future financial objectives.

CDs can have their place in financial planning, especially for saving toward short-term goals or as part of a CD ladder strategy to manage cash flow. By purchasing multiple CDs with staggered maturity dates, you can potentially benefit from higher interest rates while maintaining some liquidity. If you’re considering investing in a CD, talk with your financial planner first to make sure it will help and not hinder achieving your long-term goals.Ìý

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¹ÌýSources: Ibbotson SBBI, Morningstar Direct, Bureau of Labor Statistics as of 9/30/2023. The performance of the 60/40 mix is calculated using the weighted-average return of each asset class proxy in the following proportions: 50% consists of U.S. large-cap stocks (IA SBBI US Large Stock TR Index), 10% U.S. small-cap stocks (IA SBBI US Small Stock TR Index) and 40% Ibbotson U.S. intermediate government bonds (IA SBBI US IT Govt TR).