Don't Start Scaling That CD Ladder Just yet

Investing Low CD Rates Leave Laddering Shaky

The last few years have not been kind to those who invest in certificates of deposit.

CDs were once a good way to keep cash safe and earn a decent yield to grow your savings or give you extra cash to meet expenses. CD ladders -- created by buying CDs in a range of different maturities and rolling over cash from maturing CDs into the longest "rung" of the ladder -- were an especially popular way to maximize returns and liquidity for safety-minded investors.

However, with yields languishing these days at historic lows -- one-year maturities are earning an average of 0.24% -- CDs are about as popular as a Marilyn Manson children's album.

The total amount of money kept in CDs of less than $100,000 has fallen from $1.46 trillion in 2008 to around $571 billion today, a decline of 61%, according to the Federal Reserve.

The basic premise of CDs -- allowing investors to trade easy access to their funds for an extra cushion of yield -- has been undermined in recent years. While the highest one-year CD rates out there are still higher than the best money market accounts, the difference has shrunk to about 15 basis points, or $150 per year worth of yield on a $100,000 CD, according to research from Bankrate.com. That's not a lot of return to lock down an investment of six figures for a year.

"When rates on term deposits go down, sometimes they reach a level that the differentiation between the yield on term and liquid becomes insignificant, so people prefer to keep their money in liquid accounts," says Dan Geller, executive vice president at Market Rates Insight, a banking industry research firm based in San Anselmo, Calif.

Brian Antenucci, an investment adviser with Bartlett and Co. based in Cincinnati, says maybe that's why many investors are choosing not to roll the cash from maturing CDs from their CD ladders into new CDs.

"The clients who would be apt to use CDs are those who have to have the highest quality, and their main purpose is principal protection. You can earn a slightly better yield than U.S. Treasuries," Antenucci says. "Otherwise, there's not a lot of utility in continuing a CD ladder."

Beyond poor yields, a quick glance at the yield curve for CDs shows why ladders have fallen into disfavor. The major attraction of laddering is earning the higher rates available on longer-term CDs while still getting access to a portion of your cash at regular intervals. But that advantage has been substantially reduced by crumbling yields.

A five-year CD opened in 2008 and maturing now likely yielded around 3.5% compared to about 2.24% for one-year CDs, a difference of 1.26 percentage points. In Bankrate's latest survey, five-year CDs are averaging 0.78%, just 54 basis points higher than a one-year CD, according to Bankrate.com data.

Why rates are low

Why are banks so stingy with CD rates?

To be sure, banks are in the business of taking deposits and lending them out, Geller says. When interest rates on those loans are low, as they are now, banks aren't willing or able to pay CD investors a lot of interest on their deposits.

"As long as interest rates on loans, which is the income for the banks, are low, the banks have to maintain low interest rates on deposits, which is the expense," Geller says.

That problem is compounded by sluggish loan demand in many areas of the economy, which means banks don't need as much in the way of deposits, and so don't need to pay high interest rates to attract them.

Put another way, if demand for bread fell by half tomorrow and bakers had to cut their prices by 50%, what would you expect to happen to the price of wheat? As the suppliers of the "raw material" for loans, CD investors face a similar situation.

Add to that the Fed's decision to keep the federal funds rate near zero, and you have a recipe for historically low CD rates, Geller says. Loan demand and loan interest rates are a bigger factor than the federal funds rate because the federal funds rate is a very short-term rate and CDs are longer.

What to do about it

Estimates of how long the low-rate environment will last vary.

For his part, Geller doesn't see rates going anywhere until at least the fourth quarter of 2014, when the Fed has tentatively projected it will begin raising the federal funds rate.

Antenucci says it will likely take even longer for CD rates, which closely follow the movement of Treasury rates, to return to anywhere near previous heights. In the decade following the end of World War II, the rate on the 10-year Treasury generally stayed between 2% and 3%.

"We think there's a good chance that we could experience a similar situation where rates are low for a long period of time," Antenucci says.

In the meantime, investors, wondering what to do with money from maturing laddered CDs, have a number of options. They could earn higher yields by moving into riskier assets, such as corporate bonds or equities, but those investments don't carry CDs' "full faith and credit of the U.S. government" guarantee.

For investors who want to stick with CDs, one way to increase yields is shopping around, Antenucci says. "If people are in banks right now and they're being offered 0.3%, shop it around."

Indeed, the highest rates in Bankrate's five-year CD rate database top 1.7%, a full 1% above the average rate and enough to offset inflation, which is currently running at 1.4% annually, according to the Bureau of Labor Statistics.

Geller says those sticking with CD laddering may want to keep their ladder fairly short in case rates do recover. If you do decide to go longer to capture higher rates, it might make sense to opt for CDs offered by some banks that allow investors to "bump up" to a higher yield if overall interest rates rise.

Or investors could look at CDs that base their rates on the returns of a specific stock index to get "some kind of protection on the upside," Geller says.

Antenucci says above all, be careful to avoid making rash decisions that will lock you into today's low rates in search of a few extra basis points of yield.

"Beware the bank branch broker trying to sell you an annuity that's paying a slightly higher rate," he says, referring to an instrument with a continuing payment with a fixed total annual amount. "It may end up being tough for you to get your money out."