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Up and down the ladder with CD rates

May 11, 2011

| MoneyRates.com Senior Financial Analyst, CFA

Laddering CDs can be a useful technique for managing risk and liquidity. However, even though the image of a ladder suggests a series of evenly-spaced intervals, that does not mean you should construct your CD ladder with evenly-spaced maturity dates.

In particular, if you already have a CD ladder in place, you might be experiencing a bit of rate shock as longer-term CDs mature. CD rates are certainly significantly different than they were four or five years ago, and this should be a signal not to automatically renew your CDs at the same maturities as before.

Principles of laddering

Laddering CDs means buying CDs with a series of different maturity dates. This does not necessarily mean starting out with a mix of long-term and short-term CDs; they could all start out as long-term CDs, purchased at a series of different points in time.

No matter how you ladder your CD, it can be a useful form of hedging - spreading risk around to cover more than one outcome. Having some CDs come due sooner and some later allows you to take some advantage of the higher CD rates associated with longer-term CDs, while still hedging against the possibility that you will need some liquidity in the near-term.

Laddering also hedges you against changes in CD rates. The farther-off maturity dates protect you against falling CD rates, while the nearer-term ones allow you to take advantage if rates rise.

Significantly though, none of this depends on spacing your CD maturity dates evenly, nor does it require an auto-pilot approach to rolling maturing CDs into new ones of the same length. You can adjust your ladder to the prevailing environment for CD rates.

Adjusting the ladder to today's CD rates

Consider the current environment. CD rates are extremely low - near zero on the short end, and trailing inflation across the board. There is little room for rates to fall further, which means the probability of rate changes is skewed towards rates moving higher. Since long-term CDs hedge against falling rates, and short-term CDs position you for rising rates, this would suggest skewing your CD ladder towards shorter maturity dates.

A more detailed approach to adjusting your CD ladder depends on looking at the structure of CD rates and maturity dates available, to determine where you get the most value for each incremental move to a longer-term CD. In other words, while CD rates generally get higher as CD terms get longer, this doesn't happen in a straight line. Looking at the relationships among CD rates and terms can reveal inflection points which indicate where you get the most bang for your buck.

For example, moving out from a 3-month to a 6-month CD would earn you an extra 12 basis points, according to national averages reported by the FDIC. This equates to 4 extra basis points for each month you move out - which happens to be the biggest reward for time in today's rate environment. In contrast, moving from three years to four years nets you the least reward for time, an average of only about 2.1 extra basis points for each additional month.

So given current CD rates, a CD ladder today should be skewed towards shorter-term CDs, with weightings especially heavy at the 6-month mark, and especially light at 4 years.

Your responses to ‘Up and down the ladder with CD rates’

Showing 3 comments | Add your comment

26 July 2011 at 9:45 am

I'm really tired of hearing about laddering. There is really only one scenario when laddering makes sense: if you know that you will need cash after exactly one year. In any other case it makes much more sense (and money) if you buy several 5-year CDs at the highest APY available. If you need to cash one of them early, you may have to pay a small penalty, however, that is easily offset by the higher interest rates you earn. And if the interest rates should rise at any point during the first 3-4 years it might be worthwhile to pay the 3-month penalty and get the higher APY instead.

Richard Barrington

3 June 2011 at 5:22 am

Tyler: Thanks for your input, but I'm pretty sure quants don't spend much time buying CDs. Interest rate futures are an interesting snapshot of the market's outlook, but of course, the market is not a perfect predictor of the future. Short of trying to predict the future, one time-honored technique, whether you are a technical arbitrageur or simply trying to buy a CD, is to look for apparent anomalies in the current state of the market. That's all I am suggesting.


25 May 2011 at 6:27 pm

No actually by far the most important factor is the expectation of interest rate changes. While not a perfect forecasting model, interest rate futures should be viewed at make the smartest bet on a CD ladder. The incremental basis point spread noted above is meaningless if there is a far more important shift in rates due to the market or the Fed. This is the methodology that quants use, not silly FDIC rate averages.

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