“Diversification is the most important component of reaching long-range financial goals while minimizing risk.”
That’s what the experts say. I believe it. What about you? It’s the old, “don’t put all your eggs in one basket.”
You’re about reducing risk. Yet you also want to earn a return. That’s fair. When you spread investments across a range of categories, industries, and financial tools, you’re reducing risk. Why? Because different things do different things.
Seriously. For a specific event, all of your investments will react in a unique way. For example, a downturn in the real-estate market may elevate the risk of homeowners defaulting on their mortgages. So investments relying on that category may go down.
However, with a diverse portfolio, your financial institution can weather the storm (while protecting your account holders). We can speak with experience on this, as our company worked with a credit union holding a large mortgage portfolio…in 2008. They had a forced merger, and we lost the relationship. In that case, everyone lost.
In this article, we will talk about Certificate Investments: What they are and the Pros/Cons of each. Simply put, they are your safe and stable option. If you’re looking for high returns and volatile valuation, stop reading now. However, if you want a strong base of guaranteed returns, continue below.
Within the Certificate Investment category, banks and credit unions like yours have a range of options. We’ll help you choose which are best for your institution. Let’s look at the five main ones.
Certificates of Deposit
Yes, these are essentially what you offer to your customers. CDs guarantee an interest rate over a predetermined time period. The money gets deposited up-front and must remain, undisturbed, until maturity.
Terms vary based on the corporate credit union or investment bank your institution purchases the CD from. Typically, they range from 30 days to five years. Investors can opt for CDs that pay dividends monthly, semi-annually, or at maturity.
CDs are effective ways to put your bank’s extra liquidity to work. Corporate CDs tend to have larger denominations than those you offer to your members, typically between $100,000 and $1 million.
How much interest can you expect to yield? CD rates can vary widely, even within the same institution, so it’s important to shop around and do your research. In general, two variables determine the rate:
- Term Length
- Deposit Size
On average, expect a 1 to 2.5% return (as of article writing). Online banks and credit unions usually offer the highest rates.
- Safe & Predictable: All deposits are insured by either the FDIC or NCUA.
- Rates are locked and cannot change, regardless of market conditions.
- Rates are locked and cannot change, regardless of market conditions. (Not a typo!)
- Scenario: Your institution invests in a 5-year CD. At year 2.5, rates rise substantially. You miss out on those potential gains because the money is stuck until it reaches term.
- Penalties: If you need the money before the term is over, you’ll be charged a penalty. They vary, but typically based on term length and projected interest.
- Scenario: If you cash in a 2-year CD early, you may lose 60 days of interest. However, a 5-year CD withdrawn early may cost 150 or more days of interest.
Bottom line: Our recommendation is to only use traditional CDs on funds you don’t expect to need for the duration of the investment term. Another approach is to set up rotating terms, so you always have one maturing, if needed.
These are traditional CDs acquired during a promotion. Because everyone loves getting a great deal!
Sometimes, financial institutions offer CD Specials with higher yields and more attractive terms. The market conditions may be favorable, or they may be looking to acquire liquid funds to adjust their ratios. Either way, you benefit, as they are still fully insured and guaranteed.
During these specials, you may find “no penalty CDs” (which overcome one of their typical Cons) or rates over 3% (which protect you from losing out in an increasing rate environment).
You get more “bang for your buck”, while retaining all the guarantees and security of a CD.
They’re promotional by nature, so aren’t always available.
Note: “No penalty CDs” are sometimes called “Liquid CDs.”
Callable CDs can be “called” early by the issuing bank. The time frame and the preset call price are determined upfront, so you’ll always know the possible redeeming scenarios.
Why would a bank issue a callable CD? The “call feature” is an added protection for the issuing bank. If interest rates drop significantly, the bank can activate the call feature, so they do not have to continue paying high rates.
So why invest in a callable CD? They are usually offered with higher yields than traditional CDs. Plus, issuing banks offer to redeem their CDs at a premium of the purchase price to compensate investors for the “call risk.”
As with traditional CDs, callable CDs are zero-risk.
You may lose some interest, but your principal is always 100% protected. Plus, the agreed-upon call premium still provides guaranteed gains.
Bottom line: The most important step to investing in callable CDs is to read the terms. What premium will you earn if it is called in early? Does the higher yield plus premium make it worth passing on a lower interest CD without a callable risk?
Floating-rate CDs are also known as variable-rate CDs. They have fixed terms with fluctuating interest rates. A floating rate CD can pay monthly, quarterly, semiannually, or annually. Most CDs use the London Inter-Bank Offering Rate (LIBOR) to determine the interest rate. Penalties for early withdrawal are similar to traditional CDs.
Risk is low since you are guaranteed to at least get your principal repaid. You cannot lose your investment. The main consideration is inflation.
- Your institution can profit under positive market conditions
- When inflation is low, you’re likely to profit more than with a fixed-rate CD
- When inflation increases, your returns will not keep pace
Bottom line: If your institution believes inflation will stagnate, this is a good choice. If your institution believes inflation is on the rise, floating-rate CDs may not be an investment fit.
Step-up certificates are good options in a rising-rate environment. They still offer a fixed-rate for a predetermined period of time. However, when the term is up, the issuing bank automatically steps up your CD to a higher rate.
The idea is to help investors keep their money in the safety of a CD, while taking advantage of rising rates. Your institution agrees to the step-up rates at the start of the original CD term.
- If rates fall over the course of your term, you’ve already locked in a higher, guaranteed, rate
- If rates rise, your investment appreciates
- Step-up certificates usually start out with a lower rate than traditional CDs
Bottom line: Look at the blended yield (initial plus step-up rate) and compare that with rates you can get on a traditional fixed-rate CD. Determine which will likely produce greater profits at the end of the terms.
How to Invest in CDs
When you’re ready to invest, your institution will need a broker. No matter which you choose, they can help you pick the appropriate investment options. They will also provide reporting tools and status updates on your investments.
Ask about broker or transaction fees, as these may be waived if your funds are already with that corporate issuer.
Many corporate credit unions participate in SimpliCD Issuance. Think of this as your CD storefront. In one place, you can find issuers nationwide, for a range of terms, styles, and amounts. Choose what’s best for you, and fund it right there.
Millions of dollars in shares can be issued in a single transaction to the SimpleCD network of more than 4,300 credit unions. Curious if your corporate credit union partner participates? Visit their partner list. Some examples include Alloya Corporate FCU, Catalyst Corporate FCU, Volunteer Corporate FCU and Tricorp FCU.
We’re here to help you make educated decisions for your institution and membership. While your customer-facing products and services get the most attention, we believe your own internal strategies are just as important. This article covered Certificate Investments.
We’ll be sharing more on a range of other investments, many you didn’t even know existed!
Our Investments section focuses on ways you can safely increase your operating portfolio. Because there’s a good chance you can make more with what you already have. And just imagine what you could do with those funds.
Be sure to Subscribe to the Learning Library to stay informed on this and other topics.
Blogger. Speaker. Part-time Jedi.
Focused on helping your bank or credit union grow in the face of emerging challenges.