A Laddered Portfolio of Certificates of Deposit Can Help You Prepare for Changing CD Rates

Investors who choose certificates of deposit because they seek conservative investments for their portfolios, rather than because they are trying to match their assets to future cash flow needs, have the luxury of choosing the length of their CDs based on what they see as offering the best risk/reward trade-off. The reward part is easy to figure out -- comparing CD rates side-by-side will generally show that longer CDs have higher rates. However, factoring in risk reveals that the highest CD rates are not always the best CD rates.

This is where the concept known as laddering may come in. A laddered portfolio is one where you don't choose any one length of CD, but rather hedge your risks by buying a series of CDs at successively longer lengths. The idea, then, is that your portfolio of CDs would then resemble a ladder, with each maturity date representing the next rung on the ladder.

This is an approach which is especially valuable when you think CD rate conditions may change significantly, but you don't want to bet heavily on being right about the nature of that change. For many people, the current environment may represent just such a situation.

Current CD Rates

A recent look at CD rates showed those rates to be very low on the short end. According to Federal Reserve data, 1-month CDs were at 0.25%, and 6-month CDs were at 0.61%, though a marketplace sampling showed 6-month CDs somewhat higher, at an average of 1.53%. As expected, rates on longer-term CDs were progressively higher, with that same marketplace sampling showing 1.93% for 1-year CDs, and 2.14% for 2-year CDs.

So, if you had no pending liquidity needs, why wouldn't you simply choose the highest CD rate, and buy a CD at two years or beyond? Well, one good reason might be that you saw a storm cloud on the economic horizon: inflation.

The Inflation Concern

With the US having recently experienced year-over-year deflation for the first time since 1955, why would anyone be concerned about inflation? Well, for one thing, the fact that deflation hadn't occurred for more than 50 years should be a reminder of just how rare it is. A more specific cause for concern, though, might be the price of oil.

The price of oil fell precipitously in the second half of 2008, contributing in no small part to the aforementioned deflation. However, by early June 2009, a barrel of oil had risen some 57% since the end of 2008. This is one of the more prominent reasons why inflation has reentered the economic discussion.

Laddering CD Rates

The inflation concern poses a dilemma. If you were focused simply on getting the highest CD rate, you would choose a long-term CD. If you were focused purely on the inflation risk, you would keep your CDs as short as possible, preparing for a rise in rates.

Laddering your CD portfolio would let you do a little of both, capturing some extra interest at the long end while not exposing your full portfolio to inflation risk. There are other strategies for other situations -- such as a barbelled portfolio, which weights maturities more heavily on the extreme short and long ends -- but right now a laddered portfolio might be worth considering.

Sources:

http://www.eia.doe.gov • http://tonto.eia.doe.gov/dnav/pet/hist/rwtcd.htm

http://www.federalreserve.gov • http://www.federalreserve.gov/releases/h15/current/h15.htm

http://www.bls.gov • http://data.bls.gov/PDQ/servlet/SurveyOutputServlet

 

 

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