However, the Fed’s about-face less than a year later that led to three interest rate cuts—in three months—means that CD yields are now moving in the wrong direction: down. Financial advisors and investors considering other options to park cash might find that short-duration bond funds, or even basic money market funds, offer more attractive returns and liquidity features.
What are CDs and why do investors use them?
CDs are a deposit account that’s insured up to $250,000 by the Federal Deposit Insurance Corporation (FDIC). CDs are generally offered by banks or credit unions, and—in return for leaving a lump-sum investment in the account for a pre-determined length of time—investors receive a fixed annual percentage yield (APY).
Typically the rate of return is higher than savings account rates at a bank, yet the tradeoff is that investors have to keep their funds in the CD for the specific time frame in order to get the advertised APY rates. These time frames might range from three months to five years, for example.
Over the term of the CD, the issuer pays a guaranteed rate of interest. Investors might use a CD to generate fixed interest payments on cash holdings that they don’t need to access for a set period of time, like a down-payment on a future house, for example.
Benefits and drawbacks of CDs
Guaranteed interest payments can be both a benefit and a drawback, though. While CDs offer higher rates than savings and tend to hold interest payments steady even if the Fed lowers its key short-term rate, a fixed APY can prevent the investor from getting higher payouts when interest rates rise. To keep investors from swapping CDs when rates change, banks may also issue a penalty for early withdrawal of funds that could comprise a few months of interest payments—or more.
CDs may also be callable, which means that a bank can redeem the CD early—paying the investor back their principal and accrued interest—if interest rates fall significantly and the yield on the CD becomes higher than the bank wants to pay.
Finally, although CDs provide relative safety, their yields were extremely low in the decade after the financial crisis. This means that when taxes and inflation are factored in, investors in CDs may actually be left with negative “real” returns.
What else you can do with your cash
Investors with large allocations to cash investments including CDs may want to consider whether a mix of stocks and bonds—such as a balanced fund—could make more sense. But for investors with less excess cash who’re looking for better liquidity than a CD can offer, money market funds may be an attractive alternative; similarly, those looking for more yield may want to consider short-duration bond funds. To be clear, these two investments factor higher on the risk spectrum than CDs—as they’re not insured by the FDIC—but they may offer investors more attractive options for generating short-term income.
Money market funds are a type of mutual fund that invests in short-term debt securities with minimal credit risk. A money market fund holds various instruments such as U.S. government Treasuries and municipal securities that offer short-term liquidity.
Unless there’s a major liquidity event, money market funds generally track a daily net asset value (NAV) of $1.00. Though money market funds typically seek to preserve the value of an investment at $1.00 per share, the NAV may fall, making it possible for an investor to lose money.
Like other mutual funds, investors can buy or sell money market funds on a daily basis. Investors often use these funds as a holding account between investment trades; they may also be suitable for stowing emergency funds in case investors need quick access to their cash.
Short-duration bonds funds are mutual funds that invest in debt securities with maturities spanning a few months to a few years. While a short-duration bond fund may invest primarily in U.S. government securities, similar to money market funds, some funds also hold a portfolio of more diversified instruments like corporate bonds, asset-backed securities, U.S. government agency debt, and foreign bonds.
This exposure to higher-yielding debt instruments means that a short-term bond fund may generate higher returns than either CDs or money market funds—and at the same time, offer more protection against interest-rate risk. On the other hand, loss of capital is possible, as its NAV could decline. To balance their risk/reward objectives, investors may opt to use a short-term bond fund for cash that can remain invested for two or three years.
Choosing the right short-term investment—for you
Even long-term investors may need short-term investments. Whether you’re looking to get a return on your cash holdings that you’ll need to access in a week, a month, or a year, it’s important to choose the right option for you.
CDs may appear to be the answer, yet as we explored above, other investment options like short-duration bond funds may provide you with easier access to your funds and possibly yield a better rate of return.
This commentary is provided for informational purposes only and is not an endorsement of any security, mutual fund, sector, or index. No forecasts are guaranteed. The information contained here is based on sources believed to be reliable, but it is neither all inclusive nor guaranteed by John Hancock Investment Management.
Fixed-income investments are subject to interest-rate and credit risk; their value will normally decline as interest rates rise or if an issuer is unable or unwilling to make principal or interest payments. Investments in higher-yielding, lower-rated securities include a higher risk of default. Past performance is not a guarantee of future results.