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?