If you are looking to earn money on your cash, CDs (certificates of deposit) are a good option. Right now as of this writing CDs are earning 5% or more. The chart below shows the current CD rates available as Charles Schwab.
If you have ever bought CDs, you might have bought them at a bank. We recommend that you consider buying so-called broker CDs. These are CDs sold at your broker. There are many advantages to purchasing CDs are your broker, including:
- Many choices from dozens of banks.
- The ability to shop the highest rates among hundreds of CDs.
- The ability to configure/setup rollover and ladders easily with extensive configuration options.
- You get all the benefits of traditional bank CDs, including FDIC insurance.
Broker CDs Versus Bank CDs
The chart below summarizes the difference between bank and brokerage CDs.
Brokers can sell you traditional CDs just like they exist at banks. But they have other options, including callable CDs. Callable CDs often have higher coupon rates, but they can be redeemed before they mature at the issuing banks preference.
CDs – A Broker View
The above chart provides a summary of what you need to know about broker CDs.
The first thing is the CD CUSIP. The CUSIP is simply an identifier for the CD that is registered with the SEC. You could think of this as being similar to a stock symbol – it is a unique identifier that can be used across any broker.
The next thing to understand is the coupon yield and the a measure called APY (annual percentage yield). The coupon yield measure tells you want interest you will earn on the CD. For example, at 5%, a $1000 CD would earn $50/year, or $4/ month.
The APY measures what your total return would be if you reinvested the principal and interest for the CD for a year. For the CD on the left, it would need to be reinvested three times to get to a year since it has a three month term. For the CD on the right, it already is a one year term, so the APY does not represent any rollovers. In that case the APY equals the coupon yield.
Zero Coupon Versus Coupon CDs
CDs are similar to bonds in the way that they pay coupons. In the bond world, a bond that pays its interest only at maturity is called Zero Coupon. Institutions don’t normally call CDs using the same words, but we will call them the same. Also, if the CD pays interest or coupons along the way before it matures, we will call it a Coupon CD.
In the chart from the last section, one of the example CDs is a Coupon CD, while the other is Zero Coupon CD. When you are looking to buy CDs, this is a distinction worth noting. It can be an important consideration when you are creating a CD portfolio. We will talk about portfolios later in this article.
CD Ladders
Compared to bank accounts and money market funds, CDs tie up your money for a period of time called the term. If you are putting money away to achieve some of your short or medium term goals (buy a car, go on vacation, etc), you might not want to lock in your money too far out.
This is where CD ladders come into play. A CD ladder staggers your investment so that over time, you can get access to some of your money. Upon maturity, you could chose to simply invest it in another CD, but it gives you a benefit called optionality. Let’s consider a bond ladder pictured below.
Rung | Bond | Bond Cost |
Rung 1 | 3 month CD | 20,000 |
Rung 2 | 6 month CD | 20,000 |
Rung 3 | 9 month CD | 20,000 |
Rung 4 | 12 month CD | 20,000 |
In this example, you would invest $80K over a 1 year total term. On day one, you would setup your ladder configuration into Rungs. A Rung is simply a unit of bond term, in this example, it is 3 months.
Why would you do this? You could simply buy $80K of CDs at a one year term. The issue with that is that the money would be locked up for a year. If you wanted to get access to the money over the year, you wouldn’t have that ability.
With this ladder setup with 3 month Rungs, you get access to 25% of your money every three months. It’s your decision whether to spend the money, invest it somewhere else, or roll it over to another CD. You have options.
CD Ladder Benefits
Ladders offer you the ability to get access to your money over time, without long term lockup. Other benefits include the ability to adjust to interest rates and the ability to reinvest your CDs with automatic rollover.
CD Ladders – Viewing Them in Action
The graphic below shows you how your ladder matures over time. This shows what happens for each bond and what a rollover would look like.
On day one, you buy 4 bonds, with maturities of 3/6/9/12 months. In this example, these each earn an annual interest rate of 5%.
After three months, the first bond matures. It is reinvested in another bond with a maturity of 1 year. All the other bonds are now 3 months closer to maturity. After six months, the second bond matures. It is reinvested in another bond with a maturity of 1 year. All the other bonds are now 3 months closer to maturity.
This process repeats until all the original bonds are rolled over into 1 year bonds. Even though you now are buying longer term bonds, they still will mature in three months periods.
CD Portfolio Design
We have discussed CDs and CD ladders. In this section we put it all together to talk about how to design a portfolio. There are two main considerations: Term Selection and Coupon Selection.
Term Selection
- Rung Term
- Ladder Term
For term selection, you want to configure how often you want access to your money and how long you want to tie up your money. Shorter rung terms will provide quicker access to your money. Also consider the ladder term. Once your ladder is fully up and running, this is the CD term that all your CDs will rollover at. Longer ladder terms will require you to wait longer to stop or change your bond ladder.
Coupon Selection – Portfolio Design
- Maximize Total Return – Use Zero Coupon CDs
- Generate Income – Use Coupon CDs
When you setup your CD ladders, you can chose many different configurations. To keep this focused, we will consider the two main portfolio options above: maximizing total return and generating income.
The first thing to understand is that your broker can’t reinvest your coupons or interest payments automatically, they can only reinvest your principal.
If you are looking to maximize total return, we suggest that you buy Zero Coupon CDs. Because these bonds only pay interest at maturity, more of your money will be invested over time. There are fewer interest payments to manage, maximizing the ability to keep your money invested.
If you are looking to generate income, we suggest that you buy Coupon CDs. Because these bonds pay interest over time, more of your money will be available to take out and spend as income.
The chart below visually describes this difference.
If you purchase Coupon CDs, you can see (in this example) that you will get coupons every month. This money is available to spend because it cannot be reinvested automatically. Similarly, the Zero Coupon CD only pays one interest payment, which keeps your more of your money earning interest.
Summary
Now is a great time to buy CDs due to the great rates. Buying them at your broker gives you many more options to consider. Also, brokers have tools to enable you to build ladders, portfolios and even automatic rollover.