In today's difficult times, finding a decent return and some safety in your cash investments isn't easy.
Certificates of deposits can be an ideal vehicle because they're simple, safe and stable. They almost always offer better interest rates than savings accounts, and they're almost always backed by FDIC insurance.
Problem is, rates aren't impressive at the moment. That's partly because so many investors have fled risk, and partly because banks, which use CD deposits to fund loans, aren't issuing many mortgages. The average annual yield on a six-month certificate of deposit with a $25,000 minimum recently stood at 2.05%, and money market rates were less than 1%, according to
Brokered CDs provide a potential solution. These CDs are offered by brokerage houses such as Fidelity, Vanguard and Charles Schwab, which scour the country for the best possible interest rates. They have two distinct advantages over bank-issued CDs: the potential for higher yields and greater liquidity. But as savvy investors know, the chance for better returns typically comes with increased risk, and brokered CDs are no exception.
Here's how they work: Banks shore up deposits by entering deposit agreements with brokers. The bank issues large-denomination CDs to the broker, which essentially breaks the large CD into small pieces for sale to customers. (Bank CDs, on the other hand, are issued directly from bank to customer, in the amount invested.)
Brokers' CDs often offer better rates than the ones at your local bank. For example, in early November, Vanguard offered a six-month CD at 3.1%, with a minimum investment of just $100. Compared to the national average, that 0.81% could make a big difference, amounting to $405 over six months on a $100,000 CD.
This isn't always the case. In early November, BankingMyWay.com showed that rates for a New York City investor from
were at 4% for six-month CDs and well above 4% for 12-month CDs, better, at least over the short term, than many brokered offerings.
One of the drawbacks of ordinary bank CDs is they typically lock in your principal for a set period of time, from three months to five years. In most cases, you'll pay a penalty for early withdrawal, often 10% to 15% of the principal.
Most brokered CDs, on the other hand, can be traded, much like bonds, on the secondary market. That provides liquidity for investors who need it. In fact, your CD's value could increase, just as bonds do, if interest rates fall before you sell the CD. Say an investor had a 4% CD with a year left to maturity and the market rate for a one-year CD was closer to 3%. Other investors could be willing to pay a premium to get that 4% return.
Enhanced Risk, Too
Unfortunately, if the investor wanted to sell the CD after rates rose, he or she could lose part of the principal. That's known as interest-rate or market risk, and it should be a major consideration for those interested in brokered CDs. For example, if the investor bought a one-year, $1,000 CD at 4% and had to sell it early with rates at 5%, he or she would probably end up with about $900. And the larger the CD, the larger the potential to lose money. A recent FDIC newsletter, for example, cited a case in which an investor lost $33,000 on a $134,000 CD.
Your money may also be at risk if the issuing bank fails. With a bank account or bank-issued CD, money is usually available from the FDIC the following business day. But because brokers are involved, repayment can take longer. First, the FDIC may have to examine the broker's records to see which deposits are insured. And second, individual investors will likely have to wait until the broker is made whole, a process that can take a few weeks or even a few months, before they can recover funds.
Brokered CDs may also expose you to insurance risk. To avoid it, be sure your brokered CD is FDIC-insured. Choose a reputable broker, and ensure that your deposits at the issuing bank don't exceed $250,000, the FDIC's new limit for insuring an individual's holdings at a particular institution.
The bottom line: Brokered CDs can have advantages over bank CDs, but the risk often outweighs the potential reward. Still, it's worth shopping around to find the best combination of yield, minimum deposit requirements, maturity dates and liquidity provisions. Just remember, the point of CDs, especially in times like these, is safety and simplicity.
Mike Woelflein is a business and personal finance freelance writer. A former senior industry specialist with Standard & Poor's and managing editor of ColoradoBiz magazine, he has also written for The Denver Post and American Express.