Are CDs Good Protection For The Bear Market?

Are CDs Good Protection For The Bear Market?
by Ana Gonzalez Ribeiro (Contact Author Biography)


A bear market is usually an indication of a sluggish economy and a decrease in the value of overall securities. During this time, consumers tend to be pessimistic in their outlook about financial assets and on the economy as a whole. In a bear market, investors always tend to look into where their investments can be better protected, or which investment vehicles to add to their portfolios to help lessen the blow to their stocks and equity investments. Products investors commonly look into during these difficult times are more stable, income-producing debt instruments such as certificates of deposit (CD). But are CDs actually good protection for a bear market? Read on to find out. (For basic background on CDs, read Are certificates of deposit a kind of bond?)


What Is a CD?

A certificate of deposit is a short- to medium-term deposit in a financial institution at a specific fixed interest rate. You are guaranteed the principal plus a fixed amount of interest at maturity, which is the end of the term. The period of the term varies, but generally you can purchase three-month, six-month, nine-month, or one- to five-year CDs. Some banks have even longer-term CDs. (Learn about investing over the short or long term in Five Things To Know About Asset Allocation.)

CDs are considered time deposits because the purchaser agrees at the time of purchase to leave his or her deposit in the bank for the specific period of time. Make sure you can afford to let go of some of your money for a certain period of time before committing to a CD, because if the purchaser decides to take back the deposit before maturity, he or she will be liable for a penalty, which varies from as little as a week's worth of interest to a month or six months' interest. Any fees or penalty amounts are required to be disclosed upon opening the CD account. (Build Yourself An Emergency Fund can help you ensure you won't have to liquidate your CD in a pinch.)

One major drawback to withdrawing before the term is due is that the penalty imposed could decrease not only the interest, but also the principal amount. This can happen if you purchase a 13-month CD and decide to cash it at three months. The penalty on this CD would be to pay off six months' worth of interest. Unfortunately, your CD has not even earned that amount of interest yet – and so the penalty digs into your principal amount.

Although CDs are considered low-return investments, the return is guaranteed at the specific interest rate even if market rates go lower. Typical CDs are not protected against inflation, so when shopping for a CD, try to buy one higher than the inflation rate so that you can get the most value for your money. The longer the term of the CD, the higher the interest rate will be. Although rates on CDs are not the highest in the debt instrument market, CDs earn more in interest than most money market accounts and savings accounts. (Learn more about these two deposit options in Money Market Vs. Savings Accounts.)

CDs Vs. Stocks

Stocks tend to have a higher rate of return than most securities, but this is because of the higher risk that is involved. If a company goes through rough times, the stockholders will be the first to feel it. If the stock loses value as a result of bad management or a lack of public interest in its products or services, the value of your portfolio may be compromised. However, if the company does really well, the return you can obtain from its stock's value could be significantly higher than you would've obtained through a CD investment. (Learn more in Why Stocks Outperform Bonds.)

For the past several years, the stock market has been through turbulent ups and downs, resulting in great losses (and gains) for some stockholders. CDs are one option that can help protect your investment from these times of turmoil by providing a stable income. Although the returns gained from these investments won't usually be as high as those provided by stocks, they can serve as a "cushion" to balance your portfolio and keep it afloat when the market is down in the dumps. Because CD rates are locked in for a certain period of time, the interest rate agreed upon at the time of purchase is the interest rate that will be gained on the CD despite how poorly the market might be doing. In addition, unlike stocks and various other investment vehicles, CDs are almost always insured. (Learn how to protect your portfolio through diversification in Introduction To Diversification and Diversification: It's All About (Asset) Class.)

Guaranteed Protection

CDs are primarily a safe investment. They are guaranteed by the bank to return the principal and interest earned at maturity. The Federal Deposit Insurance Corporation (FDIC) insures certificates of deposit for up to $100,000 for individual accounts at its insured banks. This means that it will guarantee payment of your CD investment if the bank goes under. The National Credit Union Administration (NCUA) serves the same purpose for its insured credit unions.

If you have a joint account with your spouse, you can be covered for up to $250,000 (which was increased temporarily from $200,000 by the FDIC on October 3, 2008) at each institution, but if you set up your accounts under a different set of provisions (for example, as a trust), you might be covered up to an even higher amount. Check with your bank first. Knowing how much insurance you have against bank failure is essential, especially when the stock market is not faring well. It is during these times that investors tend to look deeper into insured investments. Neither the FDIC nor the NCUA insures stocks, bonds, mutual funds, life insurance, annuities or municipal securities. (For more on making sure your money is safe, read Are Your Bank Deposits Insured? and Bank Failure: Will Your Assets Be Protected?)

When searching for CD products, it is a good idea to look into how well the bank offering the CDs is doing. The FDIC has a watch list where it lists banks that might be in trouble; however, according to the FDIC, they never release ratings on the safety of financial institutions to the public. To get an idea of the how banks are performing, consumers need to visit the listings of several financial institution rating services provided on the FDIC's website. For further info visit FDIC.gov, and review detailed credit union data at NCUA.gov.

In addition to commercial banks, thrifts and credit unions, you can also buy CDs through brokerage firms or online accounts. One drawback to buying through a brokerage account is that the broker is considered a third party to the transaction - it is buying the CD from a bank and selling it to you. If a bank fails, it will take longer to get your money back because the request will have to go through the brokerage rather than directly to the bank. (Read more about the role of a broker in Full-Service Brokerage Or DIY?)

CD Laddering

CD laddering can provide a flexible security blanket if done properly. Laddering helps lower your risk while increasing your return, because it allows you to continue investing in the highest-rated CDs available. The method is to use your funds to buy CDs at different maturities and interest rates.

Here's how it works:

When you start a CD ladder, research the best rates, either locally or in different states. Let's say you have $5,000 in your minimal interest-bearing savings account. Because you want to make the most of your stationary money, you decide that a CD with an interest rate of 3% looks much more appealing. Do not use money you'll need for emergencies. After you decide this is money you can afford to lock up for a period of time, go ahead and start your ladder. You can begin by buying five different CDs at various rates and maturity dates. For example, the ladder could consist of purchasing the following CDs, each at $1,000:

a one-year CD at 3% interest
a two-year CD at 3.5% interest
a three-year CD at 3.7% interest
a four-year CD at 3.9% interest
a five-year CD at 4.1% interest

When the first CD matures, you will have the flexibility of either reinvesting by rolling it into a higher CD rate or cashing it out. In laddering, you will roll it over. When your CD matures, roll it over into a higher-rated five-year CD. When your second-year CD matures, roll it over into another five-year high-rated CD, and continue doing the same until you've rolled over all your initial CDs. Because a CD in your ladder will mature each year, you will always have liquid money available. The advantage of laddering like this is that you will always get the benefit of the highest interest by rolling into the longer-term five-year CD. (For more details, read Step Up Your Income With A CD Ladder.)

Tax Consequences

Interest that you earn on your CD throughout its term is taxable. The tax on it depends on your tax bracket. According to the Internal Revenue Service (IRS), you must report the total interest you earn on the certificate of deposit every year. Even if the interest on the CD was not paid to you directly, you will be taxed on the amount earned in that year. Interest income is considered ordinary income and taxed as such.

Conclusion

CDs are a comparatively safe investment. If they are managed properly, they can provide a stable income regardless of stock-market conditions. When considering the purchase of CDs or starting a CD ladder, always consider the emergency money you might need in the future.

Laddering can help protect your investments by providing you with stable interest income in a bear market (or any market, for that matter), but make sure you can afford to do without that money for the term of the CD, and investigate the institution you decide to buy from.

For more advice for surviving a bear market with your assets intact, read Adapt To A Bear Market and Has Your Fund Manager Been Through A Bear Market?
by Ana Gonzalez Ribeiro, (Contact Author Biography)

Ana Gonzalez Ribeiro holds an MBA with honors in Finance and works as an Account Administrator and Freelance Writer. She has published articles in The Hispanic Outlook on Higher Education, New Mexico Woman, Spotlight on Recovery Magazine and The Loop Newsletter for College Forward. She is also a regular contributing writer specializing in business-related issues for Alaska Business Monthly. She worked for The Volunteer Center of United Way Westchester as a writer for the Youth Volunteer Guidebook 2008-2009 and served as Treasurer for the Society for Hispanic MBAs. During her spare time, she enjoys collecting stamps, reading biographies, staying up to date on business-related trends and working as a Notary Public and signing agent.

http://www.investopedia.com/articles/bonds/08/CD-certificate-of-deposit-recession-bear-market.asp

http://www.investopedia.com/university/certificate-of-deposit-cd/

The humble Certificate of Deposit

Your Money
Not All Certificates of Deposit Are Plain Vanilla — or Safe

By RON LIEBER
Published: February 20, 2009
It was bad enough when big banks started going under. Then, money market funds became suspect. But now, even the humble certificate of deposit has become mired in scandal.

This week, the Securities and Exchange Commission accused a Texas financier named Robert Allen Stanford of fraud. Investigators allege that the scheme revolved in large part around the sale of about $8 billion of suspiciously high-yielding C.D.’s through Stanford International Bank.
These C.D.’s were not insured by the Federal Deposit Insurance Corporation. So once again, we’re faced with images of forlorn people trying and failing to extract their life savings.
There’s some question as to whether Stanford ought to have been using the phrase “certificate of deposit.” Most investors who hear “C.D.” immediately assume that it’s safe.
Faulty terminology or not, it’s a bad time for C.D.’s to get a black eye, given that growing numbers of people are looking for secure investments as stocks approach their bear market lows. So now that C.D.’s have been sullied, it makes sense to take a step back and review the basic product as well as other, more exotic C.D.’s that are being offered at banks, brokerage firms and elsewhere.

BASIC C.D.’S

When you buy a C.D. you hand over a pile of money to a bank and agree to keep it there for a certain period of time. In return for the certainty that it can use your funds for that long, the bank pays you interest, usually more interest than it would pay on a normal checking or savings account. Investments in C.D.’s are covered by the F.D.I.C., which currently offers insurance of up to $250,000 per person per bank. Additional coverage may be available depending on how you set up your accounts. (Links to the pertinent part of the F.D.I.C.’s Web site are available from the version of this story at nytimes.com/yourmoney.)
That $250,000 figure will fall to $100,000 for some types of accounts at the end of the year absent any new governmental action, so long-term C.D. investors need to keep that in mind.
There are plenty of places to shop for the best C.D. rates. Bankrate.com is one useful site, while MoneyAisle allows banks to compete for your business in an auction on the Web. Often, the banks offering the best rates are small banks you won’t have heard of or large banks that may be somewhat troubled.
As long as you don’t invest more than the F.D.I.C. limits, you don’t need to worry about losing your money. If the bank that issues your C.D. fails, however, another bank may end up with the failed bank’s deposits and has the right to lower your C.D. rate.
With any C.D., including the more complicated ones I outline below, there are a number of questions you should ask about the terms. Is the interest rate fixed? How long is the term? Is it callable, meaning the bank can give your money back to you before the term is up if it wants to? What sort of penalties exist if you need to take money out before the term is up? If the penalties are large enough, you could end up losing principal if you unexpectedly need the funds early.
You also want to check to see how the interest will be paid. Retirees may want a check, while others may want the money reinvested in the C.D. Also, how often does the bank pay out the interest? And will the bank try to automatically roll the money into a new C.D. when the term is up? Are there any commissions?

BROKERED C.D.’S

These are C.D.’s sold by brokerage firms, both large investment firms like Charles Schwab and small operations that maintain Web sites or try to cold-call you. They generally pool money from investors and then invest it in C.D.’s from F.D.I.C.-insured banks that the brokers find on their own. Sometimes, the banks are willing to pay better rates on brokered C.D.’s if the brokerage firm can bring a large enough pile of money to the bank.
One advantage here, according to René Kim, a senior vice president of Charles Schwab, is that you can keep multiple C.D.’s of different maturities in one account. And if you have a lot of money to put to work, you can place it with different banks to stay under the F.D.I.C. limits. Just be sure that the broker doesn’t place it with a bank where you already have other accounts, if the new money would put you over the F.D.I.C. limits.
Brokerage firms may tell you that there are no fees for early withdrawal of a brokered C.D. The S.E.C. warns, however, that if you want to get your money out early, your broker may need to try to sell your portion of the C.D. on a secondary market. You may not be able to sell it for an amount that will allow you to get all of your principal back.

INDEXED C.D.’S

These C.D.’s, also known as market-linked C.D.’s, generally guarantee that you’ll get your original investment back. They also let you share in the gain of a stock market index, like the Dow Jones industrial average or the Standard & Poor’s 500-stock index. If stocks are up during the term of your C.D., you’ll make some money. If not, you’ll still get your initial investment back, though inflation may have eroded its value.
While this downside protection and upside participation may be tempting at a time like this, these C.D.’s can be complicated. (They’re also a bit scarce at the moment, since stock market volatility makes it more expensive for banks to offer them.) Your return will depend on how the issuer of the C.D. calculates the average return on the index. So ask to see an example.
Also, the bank that offers the C.D. may not credit any of the money you earn until the end of the C.D.’s term, even though you still have to pay taxes each year on your interest.
Finally, while your initial investment may have F.D.I.C. protection, any gain during the term of the C.D. may not be covered if the bank goes under before the C.D.’s term is up, depending on how the interest is calculated and credited. Again, ask about this in advance. Also, don’t assume that your investment comes with F.D.I.C. insurance, because there are similar-sounding investments that may not.

FOREIGN CURRENCY C.D.’S

Here, you’re using American dollars to make a bet. At EverBank, which offers many foreign currency C.D.’s, you earn interest in the currency that you choose and can earn even more money if it appreciates against the dollar. If it moves in the opposite direction, however, you can lose not just your interest but some of the principal, too.
While the F.D.I.C. does insure the principal here, EverBank notes that the coverage is only for failure of the institution, not for fluctuation in currency prices. “Please only invest with money that you can afford to risk, and as part of a broadly diversified investment strategy,” its disclosure says.
The bank might as well say that you should only invest what you can afford to lose, which is not how most people normally think about C.D.’s.
So if you’re trying to stay safe, consider a plain, old-fashioned C.D. instead. And don’t ever assume, as some of the Stanford investors may have done, that F.D.I.C. insurance is automatically part of the C.D. package.
How safe is your C.D.? Write to rlieber@nytimes.com

http://www.nytimes.com/2009/02/21/your-money/21money.html?em