The Pros and Cons of Rising-Rate CDs

By Constance

Rising rates on certificates of deposit sound like the best of investing options.

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Meant as inflation protection, banks bump up interest payments on so-called rising-rate CDs when rates rise. So, you don't need to hurriedly move your money to harness higher rates or pay hefty withdrawal penalties that bite into returns when you invest in these CDs.

But this nifty feature can come with a price: Some rising-rate CDs are callable, meaning that they can be redeemed before their due date, and their initial rate may be lower than nonrising CD variations.

"What's the opportunity cost for more flexibility?" asks Robert Laura, partner at Synergos Financial Group in Howell, Mich. "If rates don't go up, are you willing to give up additional interest?"

And if they do go up, you may still have an underperforming security.

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Rising-rate CDs usually offer longer maturities. During that time span, banks usually will raise your rate only once at your request when interest rates move upward. For example, Bank of America's Opt-Up CD offers an 18-month, rising-rate CD option. If interest rates rise after six months, you can ask for a higher CD rate.

Ally offers a similar product called the Raise Your Rate CD with a 24-month maturity. You can raise your rate once during that time.

An Effective Fixed-Income Hedge

Still, rising-rate CDs can be effective fixed-income hedges. "They're good for conservative seniors who don't want to stretch for yields," Laura says.

Donald Cummings, a partner at Blue Haven Capital LLC, in Geneva, Ill., has another suggestion for other investors. Try laddering bonds, where you stagger bonds of differing maturity dates. Do this by taking a hard look at the bond's yield curve, which tracks the relationship between yield and maturity date. That way, you can see where to lay out maturities, he says.

No-penalty CDs, Treasury inflation-protected securities, or TIPS, and short-term bonds also protect you when interest rates rise. "When you buy rising-rate CDs, you're paying banks to do something you can do yourself," says Cummings.

When shopping for rising-rate CDs, here are some pros and cons worth weighing.

Rising-Rate CD Pros

Investing in rising-rate CDs is a low-stress way to ride interest rate trends. Many economists say that interest rates will rise this year. And with rising-rate CDs, you don't need to shop around, says Cummings, who warns that these rates do rise more slowly than the market.

These CDs help you avoid early withdrawals. With rising-rate CDs, you can stay in the same CDs and get a higher interest rate.

To be sure, if you do withdraw your money, you'll still be hit with charges. Bank of America's Opt-Up CD charges 180 days' worth of interest for early withdrawal on its 18-month CD. Find out about these penalties before investing in rising-rate CDs, Laura says.

Rising-Rate CD Cons

Most rising-rate CDs offer low initial interest rates. While you may get more flexibility with rising-rate CDs, you also may give up some interest. For example, Bank of America's 18-month CD only pays 0.7% annual percentage yield. However, Ally's CD pays 1.49%. It pays to shop around.

Cummings says that rising-rate CDs do have complications. For instance, some are callable on the day they rise. "You may or may not get that (higher) rate," Cummings says. "Essentially, it's a teaser rate."

Some people give up yields, expecting higher rates down the line. "Find out if the CD is callable," Cummings says. "If so, the bank will probably call them in when rates remain flat."

Also, many rising-rate CDs sold on a secondary market by dealers such as Vanguard, Fidelity and similar firms are callable. Be careful not to overpay for this type of CD or you'll lose money if it's called. "So, either buy them at par or at a discount," says Eric Randolph, a portfolio manager at Hopwood Financial Services, Inc. in Great Falls, Va. "Don't pay a premium."

Callable CDs make it hard to determine yield to maturity, or the rate of return anticipated if it is held until its maturity date. "If it's called, that would be your risk," he says.

Rising-rate CDs differ from one another. Do your homework. Know the benchmark on which the CD is based, such as Treasury-bill interest rates. Also, you may need to notify the bank yourself when interest rates rise. Only then is your rate hiked. That's how Ally Bank's rising-rate CD works.

"Fixed income investing isn't easy anymore," Laura says. "You have to look around."

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