Fixed-income investments offer wiggle room regarding yields
When interest rates start to climb, will step-up CDs be the CDs to own? Step-up certificates of deposit (also called rising-rate CDs) are fixed-income investments with a bit of wiggle room. When you have a CD with a step-up provision, you have a chance to exchange the initial yield for a better one as interest rates rise. Given currently underwhelming long-term CD yields, what CD owner wouldn’t want that option in the future?
How does the step-up work? As an example, let’s say you buy a 48-month rising-rate CD today offering an initial yield of 0.6 percent. Let’s say that two years from now, the interest rate on that CD moves north to 1.6 percent. The step-up arrangement allows you to get the 1.6 percent yield.
This is different from a traditional laddered CD strategy, in which you buy multiple CDs of varying maturities in an attempt to get higher rates of return with liquidity. Interest rates are so low right now that CD laddering has all but disappeared, and that probably won’t change in the near future. Step-ups give you a chance at a better long-term return with the same CD.
You might have to notify the bank to get a step-up. On some of these CDs, the step-up kicks in at predetermined intervals or when interest rates move up. Other banks and credit unions allow you to voluntarily request the step-up; these variants are sometimes called bump-up CDs. In both cases, there is usually a restriction that you are only allowed so many step-ups during a specific interval or during the term of the CD.1
If you believe CD rates will rise frequently in the near future, then an automatic step-up may make a lot of sense to you. On the other hand, if you only get one automatic step-up per eight months or year, you may grow frustrated at not getting them frequently enough. If you only get one step-up per CD term and you can choose when you want it, it might be better to wait than to leap at the first opportunity.
Step-up CDs are for inflationary times. Conservative investors who fear being stuck with subpar yields in the near future might want to take a close look at step-up CDs. They do offer the potential for CD investors to keep pace if inflation accelerates.
Todd Kockelman may be reached at 651-204-0655 or Todd@K-FFinancial.com.
1. foxbusiness.com/personal-finance/2011/04/11/rising-rate-cds-flexibility-price/ (4/11/11)