Rising-Rate CDs: Flexibility, With a Price

Like kids standing around the pool on the first day of summer, investors are reluctant to jump in to what's lately been a very chilly market for certificates of deposit.

"More money now than ever is basically sitting in liquid deposits," says Dan Geller, executive vice president at Market Rates Insight in San Anselmo, Calif. "We have seen a gradual shift from term deposits to liquid deposits over the last few years."

Hoping to give CD investors a little push and get back some of the billions that have flowed out of CD accounts in the past few months, banks are introducing CDs with rates that can rise along with interest rates in the wider economy.

As you explore rising-rate CDs as a possible investment tool, consult Bankrate's 2011 survey that outlines the rates and conditions of 15 step-up CDs, 61 bump-up CDs and 49 liquid CDs from around the country.

"In a rising-rate environment or the cusp of a rising-rate environment, investors are very reluctant to tie up their money in longer-term CDs," says Greg McBride, CFA, senior financial analyst at Bankrate. "So you start to see rising-rate products coming to market in an attempt to offset the objection consumers have about tying money up at a low fixed rate, only to see interest rates go racing past them."

Geller says rising-rate CDs can be attractive to investors for a number of reasons, one of the biggest being they can help investors fight rising inflation. Geller says there are signs that core inflation is picking up and rising-rate CDs are one way consumers can protect themselves.

"They are designed for inflationary times," Geller says.

Rising-rate CDs Come in Three Flavors

Most rising-rate CDs fall into three basic categories, each with its own pros and cons.

*Bump-up CDs allow investors to raise their rates a specified number of times during the CD's term. "The bump-up can be favorable as long as you're not trading away too much on the front end, and you have to be pretty good about timing as to when you're going to increase that rate in order to make it optimal," McBride says.

*Step-up CDs rise at predetermined intervals during the course of the CD's term. McBride says their greatest strength may be simplicity. "The step-up CD is actually the most straightforward in terms of measuring whether that's your best option versus a regular CD," he says.

*Liquid CDs allow investors to transfer money out of a CD, usually with some conditions on how it can be done, so it can be reinvested in higher-rate CDs should interest rates rise. "Liquid CDs really can accomplish two goals," McBride says. "You're not giving up too much in yield, and you get the ability to have not only competitive returns now, but the ability to capitalize on even better returns later without penalty."

Regardless of the type of rising-rate CDs you gravitate toward, McBride stresses that there's no free lunch.

"There's one consistency and that's if you're going to have the benefit of higher rates later, you're going to have to give up something on the front end," McBride says. "There's a trade-off."

What's the Trade-Off

To help you decide whether rising-rate CDs are right for you, Bankrate surveyed 125 rising-rate CDs from large banks and credit unions around the country. Here are a few points to consider.

*Maturity matters. The longer a rising-rate CD's term, the more time it has to make up for its lower initial yield with rate increases. The shorter the term, the less likelihood there is that a rising-rate CD would be able to match its traditional brethren.

*In most cases, rising-rate CDs' yield to maturity, or the yield investors can hope to realize over the CD's entire lifespan, trail the best conventional CDs in Bankrate's CD database. That's because our survey found many rising-rate CDs' initial yields were so low, it is unlikely they'd be able to catch up to their higher-yield, conventional cousins.

*Bump-up CDs were the most hamstrung by low initial yield of any of the rising-rate CD types. None of the bump-up CDs could match the top high-yield offers in Bankrate's database. Step-up CDs fared slightly better and liquid CDs fared best of all.

*Initial yields on rising-rate CDs varied widely in our survey. For example, on 24-month bump-up CDs, the initial yield varied from 0.15% to 1.36%, depending on the institution. So, shopping around for the highest CD rates is critical.

*Paying attention to terms is critical when it comes to choosing a rising-rate CD. We found wide variations in the way banks allowed CD investors to adjust or otherwise tweak their CDs. For instance, with liquid CDs, withdrawals could be limited to once, twice or annually during the term of the CD, depending on the CD's terms.

Overall, McBride says the question prospective investors in rising-rate CDs need to ask is, "Just how much do you have to trade away now in order to get higher rates later?"

The good news is, if you don't like any of the options we surveyed, just wait a few months and you'll probably see some crop up that are more to your liking, McBride says.

As the Federal Reserve nudges closer to raising short-term interest rates, more of these nontraditional CD products are likely to enter the market. They address what is sure to be a consumer reluctance to lock in to longer-term CDs as a run-up in the key federal funds rate approaches, he says.

Methodology

Bankrate.com surveyed the five largest banks and the five largest thrifts, based on deposits, in 10 large metropolitan markets across the country as well as the nation's 50 largest credit unions. It looked at all maturities available in step-up CDs, bump-up CDs and liquid CDs offered by each institution surveyed. In all, Bankrate surveyed 125 different products, including 15 step-up CDs, 61 bump-up CDs and 49 liquid CDs. The surveys were conducted from March 8 to March 18, 2011.