Rising rate CDs are not always the best choice for investors who are seeking to stash their cash in a liquid investment, because other options generate better yields.
While rising rate CDs appear to be a good deal since the Federal Reserve has hinted at increasing interest rates this year, investors can expect better returns from either online savings accounts, traditional CDs or a combination of both investments, according to a study conducted by Bankrate, a North Palm Beach, Fla.-based financial content company.
Rising rate CDs give investors the option to avoid being stuck with a low yield when interest rates rise, because they have the choice of withdrawing their funds without having to incur a penalty.
Investors will experience more upside by opening or maintaining both a traditional CD and an online savings account compared to liquid CDs with terms of two years or less, said Greg McBride, chief financial analyst for Bankrate. A one-year CD yields an average of 1.07% while a two-year CD yields 1.26%, according to Bankrate.
Bump-up CDs allow savers to increase their rate at least once during the term and are not a good option if the maturities are less than two years. Out of the 43 offers from 25 financial institutions, only terms of two years or longer had good deals.
None of the 19 step-up CDs produced a blended APY which beat the best yielding traditional CDs of the same maturity. These are CDs with an annual APY which increases more than a scheduled set of "steps" or increases during its term.
Callable CDs which have an embedded call option by the bank to call the CD back whenever they choose are not a good selection either. They tend to favor financial institutions and many investors misunderstand them, he said.
"We found that by and large these rising rate CDs do not make sense," McBride said. "There is no way that interest rates increase far enough and fast enough to compensate what you gave up in the initial return."
Buying a traditional CD makes more sense for average investors who should research their options for the highest rates.
"Shop around and don't take it on blind faith that just because there is the option to increase the rate, you will automatically come out better," McBride said.
While the Fed has hinted at increasing rates at its June meeting, it remains uncertain if the central bankers will boost them this summer.
The Fed's recent comments about a potential rate hike means they want to keep their options open, he said.
"The Fed is prepping the market for expectations of a hike, but it does not lock them up," McBride said. "They can't raise rates if the markets aren't expecting it because it is a recipe for volatility to occur."
The yields offered by online savings banks are "hard to beat," said Gary Zimmerman, CEO of MaxMyInterest, a New York-based company which maximizes cash balances for savers. These banks can pay the higher yields because they do not have to allocate funds for physical branches.
"You would have to go more than two years out on the yield curve to find a government bond that offers similar yield and in doing so, you would be taking duration risks," he said. "Even five-year CDs at America's largest banks only pay about half as much yield as can be obtained by keeping funds in one or more online savings accounts which offer full liquidity."
While online banks also provide CDs, the difference in the yield between their one-year CD and an online savings account is currently "so small that most people would conclude that it is better to preserve liquidity by keeping cash in a savings account," Zimmerman said.
The rising rate CDs means consumers have to take on lower interest rates today in the hopes of higher rates in the future, he said.
"As an individual investor, this is likely only a good trade if you have a very strong conviction on how interest rates will change in the future," Zimmerman said. "Bump-up, step-up or callable CDs have embedded within them an option that most retail investors will not be able to fully evaluate or price efficiently."
While a rising rate CD is a "perfectly fine choice" for an investor who is seeking a slightly higher rate of interest than a traditional CD, the catch is that if interest rates rise, the early withdrawal charge could prevent them from breaking it to move into one with higher interest rates, said Josh Alpert, a registered investment advisor at Motor City Retirement Advising in Royal Oak, Mich.
"If you are seeking a risk-free account and are willing to give up some liquidity, a rising rate CD can provide a predictable return, but with no additional potential for the term of the CD," he said.