Financial Planning

A word of caution regarding ‘Step-Up Callable CDs’

One advantage of “step-up callable CDs” is they generally pay a higher interest rate than traditional bank CDs, which is appealing to fixed income investors. However, these products come with a wide set of unique risks.

A Certificate of Deposit (CD) is a financial product commonly sold by banks that is popular among conservative investors because the deposit is protected by FDIC insurance. CDs pay a fixed rate of interest for a term of 1 month up to 5 years. Your money is committed for the term of the CD, and in exchange for the commitment, the bank pays an interest rate that is higher than what you would get from your savings or checking account.

Lately, several banks have been issuing step-up callable CDs that offer higher interest rates than traditional bank CDs. At first glance, they seem very attractive because they offer a higher interest rate while still offering the safety of FDIC insurance. However, these products have a unique set of risks that should be considered.

First, let’s take a look at what a step-up callable CD is. The “step-up” function of this CD is that the interest rate increases or “steps up” multiple times during the length of the CD’s term. Let’s take a look at an example product:

Example Product:
Coupon: 3.00% to 11/30/2022; 3.30% to 11/30/2027; 4.10% to 11/30/2032
Maturity: November 30, 2032
Payment Frequency: Semi-Pay
Call Status: Callable 05/30/2019@100, Quarterly-Thereafter

This CD pays 3% interest for 5 years until 11/30/2022, where it increases, or “steps up” to pay 3.30% for another 5 years. It increases again in 2027 to 4.10%, which it pays until maturity in 2032.

Essentially, the purchaser of this CD commits their money for 15 years, and the bank offers an interest rate that increases every 5 years. To many investors, that sounds great. The best 5-year CD rate found today is 2.45%, and the step-up callable CD starts at 3% and increases to 4.10%. One could see the appeal.

Unfortunately, this CD is also callable. That means the bank, after a 2-year period, can decide to pay you back the amount invested and you will no longer receive any future interest payments. A bank would do this if the prevailing interest rates dropped and the bank was able to issue CDs at rates lower than they are currently paying you.

If the bank calls your CD, not only do you miss out on any future interest payments and step-ups, but now you are subject to “reinvestment risk.” Reinvestment risk can best be explained by this example. If you are 2 years into the 3% period of your step-up callable CD and the prevailing interest rates drop and your bank calls your CD, you get your deposit back and lose that investment. You will now have to re-invest your money at what could be a lower interest rate. Let’s say, after your CD was called, the best available rate was 1.9% for a 5-year CD. In this case, you would have been better off buying a 5-year CD at 2.45% to begin with, instead of the step-up callable CD.

But what if the bank never calls your CD? That could be a great deal, right? Not necessarily. If the bank never calls your CD, despite having the option to, it is likely because the rate they are paying you is lower than the current prevailing rate. For example, 10 years from now, this CD would be stepping up to 4.10%, but the prevailing rate for 5-year CD’s could be 5.5%. Unfortunately, since the bank is unlikely to call your CD in this case, you are locked in to a rate that is lower than otherwise available for another 5 years.

If the bank doesn’t call your CD, your money is inaccessible for the full-length of the term. With a traditional CD, you can generally pay a penalty to receive your deposit back. Step-up callable CDs do not have this feature. One option you have is to try and sell your CD on the secondary market, but there is no guarantee there will be a market for your CD. Even if you were able to sell your CD, various market conditions could mean that you would have to sell your CD for significantly less than your deposit. This is assuming, of course, you were even able to find a buyer.

Essentially, from the bank’s perspective, step-up callable CD’s are a “heads I win, tails, you lose” product. The bank shifts interest rate risk to you. Because of this risk, the bank can offer an initial rate that is higher than prevailing rates. However, the bank enjoys the privilege of calling the CD away from you at their discretion, or forcing you to keep your money committed for a 15-year term. You can bet the bank will do what is in the greatest interest for themselves.