• Fixed-Income Strategies
  • In Today's Investment Environment, Bank CDs Deserve a Fresh Look

    by James H. Gilkeson

    Investors in today’s market environment face a variety of choices, most of them unpleasant. Equity markets recently hit six-year lows, with the S&P 500 index closing at 815.25 on September 30, 2002. This represents a decline of 46.4% from its September 1, 2000, close at 1520.77. Corporate bonds have provided some relief, but faced 2002 with record levels of default and widening credit spreads.

    At the same time, risk-free yields have fallen to truly historic lows. On January 13, 2003, the one-year constant maturity Treasury yield was 1.4%—the lowest recorded during the 40 years that these yields have been calculated. The 10-year yield was 4.1%, slightly above its 40-year low reached in late fall of 2002.

    Both equity and corporate bond markets remain uncertain. A mass “flight to quality” among battered investors has joined forces with Federal Reserve Board actions to produce minuscule yields on short-term Treasuries and other money market investments. However, investors are reluctant to seek higher returns from long-term Treasuries for fear that a significant rise in market interest rates—a distinct possibility when rates are at historical lows—will present a Hobson’s choice between accepting low returns for a long time and selling bonds at depressed prices.

    In this investing environment, investors ought to take a fresh look at a class of securities that has been out of favor for more than a decade—long-term bank time deposits, aka CDs.

    CDs, certificates of deposit, share important risk-free characteristics with U.S. Treasury securities, making them a safe haven from today’s risky corporate securities. However, they differ in important ways from U.S. Treasuries—including tax treatment and liquidity. One of the most important features that CDs offer is the early withdrawal option that allows an investor to sell the CD back to the bank for slightly less than face value.

    This article discusses the major differences between investing in U.S. Treasuries versus bank CDs.

    Treasuries and CDs

    Deposits of less than $100,000 per account at U.S. commercial banks and thrift institutions (savings and loans) are insured by a “full faith and credit” guarantee from the U.S. government, making them as safe from default as U.S. Treasury securities. Investors seeking safety from the continued uncertainty of corporate bond and equity markets can find a haven in either type of security.

    TABLE 1. Yields on U.S. Treasuries and Bank CDs
    (as of January 13, 2002)
    Maturity Constant Maturity
    Treasury Yield
    U.S. Average
    Effective CD Yield
    6 months 1.24 1.60
    1 year 1.40 1.99
    2 years 1.75 2.41
    5 years 3.10 3.61
    Source: Federal Reserve and Bankrate.com

    Despite their similarities, yields in the U.S. Treasury and retail bank CD markets can differ substantially. Table 1 provides a comparison of recent yields in the two markets. Two facts are evident from this comparison. First, the current yield curve is fairly steep, with five-year yields more than double six-month yields. Second, CDs appear to be the preferred investment choice, particularly for longer maturities of one year or more. Further, this comparison uses the average CD yields across the U.S. and significantly understates the yield advantage available to investors. A Treasury investor must accept the single, market-determined yield available to all other investors. A CD investor can shop for the highest yield. For example, on January 13, 2002, the average yield on a one-year bank CD was 1.99%, but the top five yields quoted on Bankrate.com (www.bankrate.com) ranged from 2.51% to 2.70%, a substantial improvement. Similarly, the average five-year CD yield was 3.61%, but the top five quoted yields ranged from 4.10% to 4.35%. The banks offering the highest yields included one of the nation’s largest, a few regionals, and some Internet-only institutions. In many cases, the investment could be made on-line or by accessing a toll-free number.

    Although yields currently favor bank CDs over Treasuries, there are some structural differences between the two—particularly tax treatment and liquidity issues—that should be understood.


    Interest from bank CDs is fully taxable as income at the federal, state and local levels. Interest from U.S. Treasury securities is exempt from state and local income taxes. An investor who is subject to significant marginal state income taxes—such as a resident of California or New York—will require a CD yield high enough to equal or better the same maturity Treasury yield on an after-tax basis. For example, if the five-year Treasury yield is 4.0%, an investor who pays a marginal state income tax rate of 8.0% and a marginal federal income tax rate of 28% will require a CD yield of 4.24%. (The CD investor pays state income taxes on the interest earned but receives a federal income tax deduction for these state income taxes, so the net cost of state income taxes is lower than the marginal state income tax rate.) An investor who pays a 10% marginal state rate and a 33% marginal federal rate will require 4.29%. From these examples, you can see that some of the yield differences between CDs and Treasuries shown in Table 1 may be due to the difference in tax treatments. Of course, these days an investor in a low-tax or no-tax state—such as Florida or Texas—can shop CD rates across the country at the click of a computer mouse and take advantage of the higher yields that may be available in high tax locations.


    Liquidity refers to the speed and costs associated with buying or selling a security. The market for U.S. Treasury securities is one of the most active and least expensive in which to trade in the world—although it is not always costless. Commissions at discount brokers are typically in the range of $25 for trades up to $100,000 in face value. Bid-ask spreads—the difference between the price an investor can buy at and the one he can sell at—are tiny. Individual investors also have the option of buying Treasuries commission-free directly from the government through its Treasury Direct service.

    In comparison, banks typically charge nothing to issue a new CD and many have devoted significant resources to develop on-line and telephone systems that make it easier to invest in CDs and access other bank products. In summary, on the buying end, there is little cost associated with investment in Treasuries or CDs.

    More differences are apparent on the selling end. Because Treasuries trade in an active secondary market, a seller can always find a buyer. However, as the market’s yield requirement changes, so will the price it is willing to pay for an existing bond. There is an inverse relationship, with rising rates implying falling prices, and vice versa. In today’s rate environment, a five-year Treasury would lose a little more than 4% of its market value if market yields rose by 1%.

    In contrast, bank CD values are not subject to the same market forces. Most retail (under $100,000) CDs contain an embedded option or right provided to the investor that allows him or her to sell the CD back to the bank in exchange for full value (principal plus accrued interest) less a pre-specified early withdrawal penalty. Penalty rates vary from one institution to the next, but are often quoted as a portion of the annual interest rate. A survey conducted of 22 banks and thrifts in the Orlando, Florida, area found early withdrawal penalties on five-year CDs ranging from three to 12 months of foregone interest, with the most common penalty rate being six month’s interest. At current CD yields, this equals a penalty of roughly 2%. Further, banks that offered higher yields did not generally compensate by charging a higher withdrawal penalty.

    Early Withdrawls

    The early withdrawal option embedded in CDs is similar to the prepayment option provided mortgage borrowers in the sense that pure option pricing models will not correctly determine the value because investors rationally withdraw CDs before maturity for a variety of non-financial reasons. To focus on the financial benefits of the early withdrawal option, we provide estimates of the total return pick-up that would be realized by investing in bank CDs compared to two alternatives: a same-maturity Treasury security, and an initial investment in money market instruments—likely through a money market mutual fund—that is rolled into a longer-term security if interest rates rise.

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    For simplicity, we assume that the investor has a five-year horizon and desires a default risk-free investment. Three alternatives are available: a five-year bank CD with an early withdrawal option paying 4.0%, a five-year Treasury note paying 4.0%, and a money market investment paying 2.0%. The early withdrawal penalty on the CD is six months’ interest, or 2.0%. All CD and Treasury yields are the same with four-year yields of 3.5%, three-year yields of 3.0%, and two-year yields of 2.5%. These assumptions capture the flavor of today’s interest rate environment, but with nice round numbers.

    We’re interested in the total return earned by the investor in a rising interest rate environment. The Treasury note always earns a return equal to the 4.0% yield compounded for five years, or 21.7%. The money market earns the 2.0% annual yield until rates rise and then the longer-term CD yield for the remaining years. For example, if rates rise by 2.0% after two years, the three-year CD rate will rise to 5.0%. The money market alternative will earn 2.0% for two years, then 5.0% for three years, for a total return of 20.4%.

    If the CD is never withdrawn, it will earn the same total return as the Treasury security, 21.7%. If it’s withdrawn before maturity, its total return will reflect earning the original CD yield, paying the withdrawal penalty, and reinvesting at the new CD yield for the remaining years. If we use the same example as before, with rates rising by 2.0% after two years, the CD investor will earn 4.0% for two years, pay a 2.0% penalty, and then earn 5.0% for three years, for a total return of 22.7%.

    Under these circumstances, because of the early withdrawal penalty option, the CD investment outperforms the Treasury and money market alternatives by 1.04% and 2.27%, respectively. For simplicity, we ignore the potential difference in taxes by assuming the investor lives in a state with no local income taxes.

    Table 2 provides the total return improvement of the CD investment over the Treasury and money market alternatives under a variety of conditions. In all cases, market yields are assumed to increase only once (by 1%, 2%, or 3%) after a period of time (one, two or three years) and remain stable thereafter. In the money market alternative, the investor invests in a CD immediately after yields rise. In the CD alternative, the investor only withdraws the original CD and reinvests the proceeds if that choice provides a higher total return than retaining the original CD until maturity. In other words, the CD investor is assumed to exercise the early withdrawal option only when doing so will improve his or her total return.

    TABLE 2. CDs vs. Treasuries and Money Markets: Current Interest Rates and Penalty
    (for a Five-Year Investment Horizon)
      Increase in Total Return for CDs Compared to:
    Interest Rates Rise By Treasuries
    If Rates Rise After:
    Money Markets
    If Rates Rise After:
    1 Yr 2 Yrs 3 Yrs 1 Yr 2 Yrs 3 Yrs
    1.00% 4.63% 7.99%
    2.00% 4.60% 1.04% 2.27% 5.78%
    3.00% 9.45% 4.58% 1.03% 2.33% 4.58%
    Assumptions: Equal Treasury and CD yields of 4.0% for five years, 3.5% for four years, 3.0% for three years and 2.5% for two years; money market yield of 2.0%; early withdrawal penalty of 2.0%; all yields increase by the same amount and remain the same thereafter.

    These results provide some interesting lessons. The early withdrawal option provides value over the Treasury investment only if market rates increase by a significant amount, because the CD investor must “earn back” the withdrawal penalty. The increased return also diminishes if it takes a longer time before rates increase, because there is less time to earn back the penalty. The option provides no value over the money market investment if market rates increase quickly, because the money market investment starts earning the new, higher rate and the extra CD yield during the first year goes to “pay for” the early withdrawal penalty.

    The lessons learned in this example can be made clearer by examining two alternatives to the situation assumed in Table 2.

    In the first alternative, we assume that the difference between short-term and long-term yields is 1.0% instead of 2.0%—that is, that money market yields (and the one-year Treasury yield) are 3.0% instead of 2.0%, with 0.25% for each additional year of maturity up to five years, which would still have a yield of 4.0%.

    In the second alternative, we assume that the early withdrawal penalty is a full year’s interest—4.0% instead of six month’s. The results from these new assumptions are provided in Table 3 and Table 4.

    In Table 3, when the difference between long-term and short-term rates is less, we see that the CD alternative outperforms the Treasury alternative by even larger amounts. This occurs because when all rates rise, the CD investor can withdraw and reinvest at a higher rate than we had previously assumed. However, when long-term and short-term rates are closer together, it’s harder for the CD alternative to outperform the money market alternative. In fact, if interest rates rise quickly, the CD alternative will underperform the money market alternative, no matter how much they rise.

    TABLE 3. CDs vs. Treasuries and Money Markets: 1% Difference Between 5-Year and Money Market Rates
    (for a Five-Year Investment Horizon)
      Increase in Total Return for CDs Compared to:
    Interest Rates Rise By Treasuries
    If Rates Rise After:
    Money Markets
    If Rates Rise After:
    1 Yr 2 Yrs 3 Yrs 1 Yr 2 Yrs 3 Yrs
    1.00% 1.04% -1.30% 0.60% 2.91%
    2.00% 5.80% 2.80% 0.45% -1.35% 1.07%
    3.00% 10.69% 6.37% 2.78% -1.40% 1.09%
    Assumptions: Equal Treasury and CD yields of 4.0% for five years, 3.75% for four years, 3.5% for three years and 3.25% for two years; money market yield of 3.0%; early withdrawal penalty of 2.0%; all yields increase by the same amount and remain the same thereafter.

    In Table 4, when the early withdrawal penalty is a full year’s interest, there are fewer times that the CD investment will outperform the Treasury investment, because it takes a larger yield increase for a longer amount of time to earn back the penalty. Also, if the early withdrawal penalty is higher and rates rise quickly, the CD alternative will underperform the money market alternative by a greater amount. It may be confusing that, in some cases, the total return improvement of the CD alternative over the money market alternative does not change when the early withdrawal penalty increases. In these situations, it is not optimal for the CD investor to withdraw and reinvest the CD, given the penalty, the increase in rates, and the remaining time, so the increase in the penalty makes no difference.

    TABLE 4. CDs vs. Treasuries and Money Markets: 4.0% Early Withdrawal Penalty
    (for a Five-Year Investment Horizon)
      Increase in Total Return for CDs Compared to:
    Interest Rates Rise By Treasuries
    If Rates Rise After:
    Money Markets
    If Rates Rise After:
    1 Yr 2 Yrs 3 Yrs 1 Yr 2 Yrs 3 Yrs
    1.00% 4.63% 7.99%
    2.00% 2.02% -2.68% 1.23% 5.78%
    3.00% 6.78% 2.00% -2.78% -0.25% 3.55%
    Assumptions: Equal Treasury and CD yields of 4.0% for five years, 3.5% for four years, 3.0% for three years and 2.5% for two years; money market yield of 2.0%; early withdrawal penalty of 4.0%; all yields increase by the same amount and remain the same thereafter.


    A number of interesting lessons can be learned from this article for investments in the current market environment, characterized by chaotic equity markets, rising corporate default rates and historically low default risk-free yields:

    • First, in order to avoid default risk yet earn longer-term yields, an investor should consider the possibility of investing in retail bank CDs rather than U.S. Treasury securities or money market investments;


    • Second, investors should shop for the best CD rates;


    • Third, the early withdrawal option embedded in bank CDs allows investors to pick up long-term yields while avoiding being locked-in if rates should rise significantly from their current levels; and


    • Fourth, investors should shop for low withdrawal penalties in addition to high CD rates. One exception to these lessons comes if investors believe that market rates will rise significantly in the very near future (less than one year). In this case, temporary investment in money markets with an intention to roll into longer-term securities after rates rise may be preferable to an initial investment in CDs.

    Although it is possible to invest in a CD at just about every insured commercial bank, savings and loan, and credit union, our research indicates that local bank branches rarely offer competitive rates. Therefore, this “how to” discussion focuses on using the Internet to find the best available rates.

    Our favorite Web site for this purpose is Bankrate.com (www.bankrate.com). From the main page, click on the Best Rates link (currently at the center of the page), then click on High Yield Savings. After selecting a maturity, a list of the best rates currently available for that maturity appears, ordered from highest to lowest. Each listing provides the name and toll-free number of the institution, its rating, the CD rate, compounding frequency, and annual percentage rate, or APR (interest rate after compounding), and the minimum required deposit. Some listings also contain a direct link to the institution’s Web site.

    The ratings, computed using data the bank submitted to federal regulators, range from five stars (five stars = superior) down to one star (one star = weak).

    All bank deposits under $100,000 are FDIC-insured (or NCUA-insured in the case of credit unions). However, despite this protection, an investor may wish to avoid institutions with ratings below three stars, as there may be some delay in extracting funds from an institution that fails—even though the deposit is federally guaranteed.

    Bankrate.com also allows users to search for rates by location. While this feature does not locate rates that are higher than the best rates option, it does allow a direct comparison to local banks. If an investor is only looking to place a small amount of funds (e.g., $1,000 or $2,000), it may be worthwhile foregoing a higher yield in exchange for the convenience of local access. The one piece of useful information not provided on Bankrate.com—or any other site comparing CD rates across many banks—is the withdrawal penalty. However, many of the individual institutions’ Web sites list the withdrawal penalties they charge. If penalty information is not easily obtained on-line, the investor should call the institution to find out what it is.

    There are many other Web sites that claim to list the most competitive rates available. Some of these—the ones that compare rates across many institutions—are worth looking at. Other sites are actually affiliated with specific banks and provide rates only for those institutions. These affiliated sites should be avoided, as they typically offer rates no better than could be obtained at local bank branches.

    Three useful sites, each with unique characteristics include:

    • Money-rates.com (www.money-rates.com): The closest to Bankrate.com. From the main page, select CD Rates and follow the instructions to see a list of the highest available rates and the institutions offering them.


    • AmazingRates (www.amazingrates.com): Allows its users to search by maturity (called term), city, and zip code. This site seems to focus on credit unions, which offer very competitive rates, but are available only to investors who are eligible to join the credit union.


    • Bank-CD Rate Scanner (bankcd.com): Approach is slightly different than the other sites. It requires the user to enter his or her name and E-mail address. The site then sends a confirmation E-mail that the user must reply to (no specific message is needed, just a reply). Then the site (very quickly) sends an E-mail containing a list of the highest available CD (and other savings) rates, along with the name, telephone number, and Web site address of the institutions offering them. In our experience, this was the only E-mail received as a result of our query—it did not start a flood of spam (junk E-mail).
    In summary, the Internet is a great source for finding the best CD rates and even an investor who does not have a computer at home can obtain access at his or her local library.

    Remember, however, that part of the CD investment process requires that the investor compare withdrawal penalties for the highest-yielding CDs and find the best high-rate, low-penalty combination. Unfortunately, this information is not readily available on-line—at least not from a source that compares both penalties and rates across banks. So investors will have to do some legwork to find the best very deals.

    Investors may also wish to avoid banks with low safety and soundness ratings, even though their deposits would ultimately be insured should the institution fail.

    James H. Gilkeson , Ph.D., CFA, is associate professor of finance at University of Central Florida, Orlando, Florida.


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