Investing in CDs

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Investing in CDs: 2 “Safe Harbor” Investments Right Now

by Floyd G. Brown, Advisory Panelist, Investment U
Wednesday, July 30, 2008: Issue #829

I walked into the University Place Branch of Bank of America on Saturday morning and was eyewitness to a shocking run on the bank. An unruly crowd had taken over the lobby of the branch. Every station in the normally deserted suburban banking center was full of customers.

Then I noticed a sign in the window. “Branch hours are extended today to accommodate all the customers wishing to open a High Yield 4% Certificate of Deposit.”

These customers weren’t demanding to withdraw their money; instead, they were rushing to make deposits. Bank of America was experiencing a reverse run as investors hurried to start investing in CDs guaranteed by good ol’ Uncle Sam at the biggest bank in America.

Fleeing other investments and the ravages of a bear market, they were trying to protect their money in FDIC insured savings products. Many of these investors may wind up worse off than when they started. “Safer” investments fail to keep up with rising inflation. But there are ways to protect your returns and limit your interest rate risk if you are investing in ultra-safe CDs.

A Glorious Bull Market Goes Bearish

From the early 1980s until 2000, America’s stock market experienced a glorious bull market. The S&P 500 climbed a steep mountainside from 100 to 1,500 points. The average investor in this market became a genius. Every broker was a maestro.

But bulls don’t last forever, and the bears finally showed up. Since 2000, returns have been negative, or flat at best, in the S&P 500, which tracks the performance of America’s 500 largest public firms. Many undisciplined investors have fared far worse. Now that same broker is transformed from a maestro to a goat.

The generation most invested in this market of the last 10 years is my own – the baby boomers. This generation, which gave America free love, Woodstock and the Internet, are scared. As a group, we haven’t saved much for retirement anyway.

Now we find ourselves preparing for retirement with a foreclosure notice in one hand and a bank CD that won’t match inflation in the other.

The Mirage of 4% CD Rates

The safety of a 4% CD is a mirage in the desert of high inflation. Consumer prices rose at an annualized rate of 7.9% in the second quarter. They had already increased at 3.1% in the first quarter of 2008. In 2007, inflation rose by 4.1%, whereas year-to-date we’re already up 5.5%.

Our parents suffered a similar fate while we were partying our way through the 1970s.Their experience tells us that instead of a CD yielding 4%, a better alternative would be stocks in sectors that can hold up in inflationary times – stocks with rich dividends.

Assets such as stocks will do a better job of holding value during high inflation. Why buy a CD at 4% when stock in companies such as:

General Electric (NYSE: GE) yields 4.3%.
US Tobacco (NYSE: UST) yields 5%.
Pfizer (NYSE: PFE) yields 6.8%.
Dow Chemical (NYSE: DOW) yields 5.1%.

These yields are eye-popping by most historic measures. You can pocket these and other dividend payments until the market rebounds. These companies will pay you to hold their stock.

Investing in CDs – Consider Laddering Your CD Portfolio

If you feel compelled to flee for the safety of CDs, or if you need to hold a large portion of your portfolio in these obligations, then at least consider “laddering” your CD portfolio.

Laddering is a lot like dollar-cost averaging when you buy stocks. With laddering, you stagger the maturity dates to take advantage of rising rates.

It works like this…

You don’t invest all your CD money in a single maturity date.
Instead of putting all your money in one product, you buy several.
If you had $50,000 to invest, you would acquire a $10,000 one-year CD, a $10,000 two-year CD and so on until your last $10,000 buys you a five-year CD.

Each CD is like a rung on a ladder. When the one-year CD matures, you reinvest that money in a five-year CD. The cycle repeats, and gives you the ability to reinvest at better rates. Some of your money will always be less than 360 days from maturity.

Interest rates often climb in periods of inflation. Each year you will have an opportunity to grab the higher rates if they appear.

However, if you can sleep at night and still own stocks, then holding on is my recommendation. In the end, most bank CDs will leave you worse off after price inflation. Besides, I hate waiting in lines.

There are no guarantees, but history has shown that individuals brave enough to buy stocks in bear markets are better off in the long run.

Good investing,

Floyd

Today’s Investment U Crib Sheet

Inflation risk is a big concern for investors and retirees who use their fixed income investments to maintain a standard of living. Fixed income investments such as bonds, CDs and money markets can see their purchasing power eroded as investors find their money doesn’t buy as much as it used to.
Inflation Risk is the risk that purchasing power will be reduced by increased costs of goods and services.

Treasuries and certificates of deposit are considered safe because they protect the principle amount invested against loss. But they do not protect against inflation.
The yield curve is the relationship between the cost of borrowing and the time to maturity for debt. It gives you the financial benefit of ultra-safe fixed investments, and the rate of return for tying up your money for that period.
With inflation rising by 5.5% year-to-date, there isn’t an investment that you can make in U.S. Treasuries that won’t be losing money against inflation risk.
Investors looking to protect themselves against inflation have few attractive choices right now. But Alex Green recently showed us why we should put our money to work today in the ultimate inflation hedge.