Over the last couple weeks I’ve written quite a bit about fixed investment options. So far I’ve yet to hit on my personal favorite, the CD Ladder. The idea here is simple, you need a way to maximize your return on the fixed portion of your portfolio while limiting your risk to rising interest rates.
What is Interest Rate Risk
What is interest rate risk you ask? Well, we previously talked about the changing value of money here. If you recall inflation is the measure of the change in how much you can purchase with your money over time and it’s driven by the perception of what backs money and the amount of money supply. Inflation hits a single fixed investment in a number of ways.
Impact of Interest Rate Changes on a Bond
The first simple concept is the purchasing power of the money you have left after your return and the inflation. For simplicity’s sake you have a 0 coupon bond that grows at a 2% annual interest. A 0 percent bond is one that pays out no money until maturity at which case it has grown by the fixed rate per year until the point of sale. Now if inflation over this period is also 2% then your money has not increased in purchasing value from year to year while holding this bond. If the inflation were higher or the annual interest were lower you might actually look at it as the total value of what you could buy is less tomorrow then it is today. Needless to say, it’s not ideal.
The second impact is a little harder to understand, and that is the pricing of the security itself. The price of a bond/cd/etc moves as the inverse of its yield. As interest rates change in the overall bond market the price of your bond changes. The reason for this is simple. Why would you pay the same price to own a bond that improves your purchasing power as one that just maintains that power? You wouldn’t. Thus, your bonds must proportionally price reduce to the change in interest rates of newly available bond issues. The change in interest rates of newly available bonds issues does not have a 1:1 relation to inflation. However, inflation is a significant driver of interest rates of the bond market as a whole. Therefore, as inflation rates rise your bond is likely to decline in value. This means selling a bond and replacing it with one of a higher return will not offset inflation changes that have already occurred.
A CD Ladder as Interest Rate Protection
So, what’s an investor to do? Easy, purchase safe investments in such a way as to return as much as possible while mitigating interest rate risks. Bank CDs, as opposed to brokerage CDs which are a topic for another day, are a fantastic instrument to use for this purpose. Many bank CDs have an early withdrawal clause, that means the security is liquid for potentially a minor penalty of a few quarters interest. What this means is if the interest rate rises rapidly on other bond issues, you spend one quarters interest in order to repurchase with a higher bond return. So right off the bat the CD has some superior aspect of inflation protection when we see a large change in rates. A lower change though may not justify the withdrawal penalty.
That is where the ladder concept comes in. Typically when you purchase a CD, the longer the time interval the higher the interest rate. The problem is the longer the time period the more likely these minor changes in inflation are likely to eat into your return. So, a secondary mitigating step you can take is to buy the CD’s staggered over the course of the time interval. The effect of this is when the CDs mature they do so staggered, but you can purchase longer maturities for higher returns. Thus they can be reinvested as rates gradually rise in such a way as to not lose too much to changes in interest rates while not having to pay back a quarter or 2 of interest.
How to Build a CD Ladder
A 10 CD ladder would currently be receiving about 3% on new issues and anywhere up to about 4% on issues on the older end of the scale. This would give a blended return of somewhere near 3.5%, which exceeds todays current bond issues. It would also provide more inflation protection then today’s individual bonds since you would be able to reinvest a bit of it as rates change each year. The only issue? It takes ten years to build out a bond ladder like this. In order to ease yourself into that ladder, consider buying CD’s of different maturities to build out a maturity schedule similar to the length of ladder you will ultimately buy as longer duration bonds. This coupled with contributing new money over time should get you to a CD ladder before you know it.
Do you ladder CDs for the safe portion of your investment?
I have always really liked the idea of a CD ladder in theory, but have yet to put one together. Do you find that there is a certain dollar value at which it makes sense to start putting one together? I would imagine it doesn’t make sense in terms of effort and return to ladder a $10k emergency fund (or does it?), but at what point does it start making sense?
Thanks!
I’d suggest 10k and above would work ok. Anything less and it wouldn’t be worth your time since cds tend to sell in 1k denominations. An emergency fund is a great application for a cd ladder. At $10k the extra 2.5 percent over a savings account a year would be 250 dollars.
Very curious what other comments are here. I am 45, and virtually no money in cds or bonds. 100% stocks. Reason being my safe money can be the equity in my house or the combined salary of Me + Mrs. Now if I would lose my job then I would have to lean on the home equity until I get rolling again (Have an open line already). Even at 45, I look at any new money saved as a 20+ year savings. Maybe as I get closer to the goal I will go less risky and have more cds or bonds but unless I’m trying to live off the interest at some point, I can’t see if for me personally. Awesome explanation though.
100 percent Stocks is ok if you have a great backup plan and a super high known risk tolerance. The latter is he real problem, it’s a rare person that could tolerate a fifty percent drop in everything they’ve made in their life. As noted I wouldn’t use an equity line of credit as a backup plan. However your families professions and employers could be sufficiently diversified to significantly lower your risk. From there if you had multiple sources of income or guaranteed to be accessible debt I can see it being a good plan.
Chris, I don’t like the idea of treating home equity as safe money or emergency money. This is because home equity loans normally have variable interest rates that will likely to go up and make loan payments expensive over time and secondly you are tying your house to additional debt/risk which upon default can cause you to lose your home.
A safer approach would be to have an emergency cash set aside in a CD or savings account to cover expenses for several months in case of loss of job or some other big emergency.
Another reason to not use home equity is your betting on the lending source being solvent in a downturn. Thanks for adding your thoughts mr all things money.
I have to say this is a great strategy that I have yet to employ. I have been a stock market guy most of my life and I was really turned off bonds due to a bad professor in college. That’s a poor excuse but it turned me off to fixed income for awhile. Thanks for the excellent overview and I will definitely be applying what you thoroughly explained 🙂
I can imagine CD ladders will become more popular over the next few years as interest rates continue to rise. Mid and long-term rates have been so low for so long now that I can’t imagine too many people have put together CD ladders over the last 5-7 years.
I’m hoping that by the time I retire or get close to it, rates have increased to where I can build a CD ladder to lock in a nice stable return. I’ve got a little ways to go, so for now I’ll be sticking to more growth investments.
So true, part of me putting this post together I guess is to say I foresee an upcoming return to prominence and need.
Great post. We’ve never used a CD ladder but this is a very viable way to grow and protect your safe money. The only CD we had was a no penalty CD at 4%. Those were the days.
Thanks for sharing.