Offbeat Offerings: Brokered Certificates of Deposit
by Cara Scatizzi
Most investors have, at one time or another, parked a sum of money in a bank certificate of deposit (CD). A typical bank CD bears a maturity date, a specified interest rate, and is insured for sums up to $100,000 if the issuing bank is insured by the Federal Deposit Insurance Corporation (FDIC).
Traditionally, individual investors have purchased bank CDs through local banks. But in todays market, individual investors increasingly have access to brokered CDs, which are CDs issued by a bank and sold through a brokerage firm. The allure of these brokered CDs is the possibility of higher rates compared to a traditional CD purchased through a local bank.
How It Works
Traditional bank CDs are relatively low-risk investment vehicles with typical maturities ranging from one month to five years. As interest rates rise and fall, so do the rates banks will pay for new CDs. If the CD is held to maturity, the investor is guaranteed the original deposited amount plus the accrued interest. CDs offer a higher interest rate compared to a checking or savings account because a typical bank CD will prevent the buyer from cashing out prior to maturity by charging an early withdrawal penalty.
Brokerage firms can negotiate higher interest rates on bank-issued CDs by promising more customer deposits to the bank. A brokered CD is typically created when a bank sells a brokerage firm a large block of CDs at an advantageous rate due to the size of the block; the brokerage firm will then divide the CD into smaller portions for its customers.
Many of these brokered CDs have maturities that are much longer than traditional bank CDs; some extend as long as 20 years.
Both brokered and traditional CDs issued by insured banks carry FDIC insurance up to $100,000 per financial institution, per account owner.
The two CDs part ways when it comes to early withdrawal of funds.
A bank will charge customers a penaltytypically several months interestto redeem the CD funds prior to maturity.
In contrast, if an individual wants to cash out of a brokered CD, most brokerage firms will purchase a CD from an investor prior to maturity without charging a fee. However, the repurchase may occur at a price that is less than the full maturity value of the CD, depending on how interest rates have changed. If interest rates on new CDs are higher than the rate on the CD being repurchased, the CD will be repurchased at a discount. Thus, brokered CDs face interest rate risk similar to that faced by bondholders.
In short, if you purchase a brokered CD and sell it before maturity, you may have a loss that is more than a banks early withdrawal penalty, and perhaps even a loss that eats into the original deposit. This repurchase feature is more advantageous (compared to a bank CDs early withdrawal penalty) only if an investor is selling a CD with an interest rate less than or equal to the market rate for new, similar CDs.
Types of CDs
Brokered CDs can have numerous features tacked onto them, making the safe investment slightly more risky.
Like a callable bond, brokered CDs can include a call provision. If interest rates fall, the firm may take back your CD so it can issue new CDs at a lower rate. While you will receive your principal and the interest earned during the actual holding period, you will have to reinvest your money at a lower CD rate, missing out on higher interest payments.
Some brokered CDs, called step-down CDs, can have variable interest rates that start out at an attractively high rate and slowly decline over time.
Stock or commodity market brokered CDs have interest rates that are tied to a commodities or stock index return, making it as volatile as the respective market.
How to Buy
Most large brokerage firms offer brokered CDs. The investment brokerage firms Web site will have current rates and details about their offerings.
To find the best deal, make sure you compare rates offered at various firms. Also make sure you check on the underlying banks financial condition. (See Additional Resources at the end of this article.) All transactions will be made through the brokerage firm itself, so make sure you are dealing with a reputable broker.
As with all investments, there are many things to consider before purchasing a brokered CD.
First, carefully read the disclosure statements to make sure you understand all of the terms of the underlying bank CDfor instance, who the actual CD issuer is; when the CD matures; if there any call features; what interest rate is paid, if it fixed or variable and how often it is paid; and if there are any withdrawal penalties.
Second, make sure you understand details relating to the brokerages holding of the CD and how it is titled. If the CD has been split among several investors and the brokerage firm does not list each owners name in the title, make sure that the account records reflect that the broker is acting merely as an agent for you and the other owners.
Third, make sure you understand what may happen if you want to cash out of your CD before maturity. Lastly, make sure your CD is federally insured, and keep in mind that FDIC insurance only covers up to $100,000 per financial institution.
Type of Investor
A fixed-rate, fixed-return CD from a bank or a brokerage firm can be a safe investment for excess cash. CD rates are locked in and will not fluctuate with market interest rates, assuming you hold it to maturity. The rates are higher than a traditional savings or checking account and, assuming you have done your homework, are FDIC-insured.
The more provisions tacked onto the CD, the more risky it becomes. Callable, adjustable-rate and market-indexed CDs will not offer the same level of safety as traditional CDs.
Insured bank and brokered CDs are typically very safe. Investors are guaranteed the return of the original investment amount plus an interest payment based on a predetermined fixed rate, if the CD is held to maturity. FDIC-insured CDs are also insured up to $100,000.
Higher Interest Rate
Because brokerage firms can bring a large number of deposits to a bank, they can sometimes negotiate a higher interest rate. A CD will almost always have a higher interest rate than a checking or savings account.
Longer Maturities and Riskier Provisions
Brokered CDs can include provisions that make them much more risky and illiquid, including longer maturities, call options, variable interest rates and rates linked to more risky investments like stock indexes and commodities.
Withdrawal Before Maturity
If an investor wants to cash out of a CD before maturity, typically the broker will repurchase the CD for resale to another investor. If interest rates have risen, the CD will be repurchased at a discount, possibly resulting in a loss that could be more than a banks early withdrawal penalty and could even eat into the original deposit.
Bank and Credit Union Ratings
Although brokered CDs are offered through a brokerage firm, they are still issued and backed by a bank. It is always a good idea to check an unbiased ratings service for the banks financial stability before investing. BauerFinancial analyzes and reports on the financial condition of the nations banks and credit unions based on their filed financial reports. The site independently analyzes the data and supplements it with additional research and historical data. For each bank or credit union, a star rating from zero to five is assigned. The information provided by BauerFinancial is free.
Comparing CD Rates
Bankrate.com continually surveys 4,800 financial institutions in all 50 states with the goal of providing unbiased rates to consumers. Bankrate.com provides free rate information to consumers on more than 300 financial products, including CDs.
By Cara Scatizzi
AAII Associate Financial Analyst