Millions of American investors buy certificates of deposit (CDs) at banks and credit unions. But did you also know that you can buy them through investment brokers? They are called traded CDs.
At their core, bank CDs and traded CDs are the same product. But on closer inspection, there are several key differences. These include how they are purchased, options for maximizing FDIC coverage, and other provisions. This article covers broker CDs and how they work to help you decide if they’re right for your portfolio.
Contents
- Bank CDs
- Traded CDs
- How do traded CDs work?
- Callable or non-callable CDs
- Are traded CDs risky?
- Comparison of traded and bank CDs
- Traded CDs
- Bank CDs
- Is a negotiated CD the right choice?
- The Basics of Traded CDs
Bank CDs
Bank CDs are locked savings accounts provided by a bank or credit union. It is a savings contract in which the bank agrees to pay a fixed interest rate for a fixed period. Considered a safe investment, terms can range from three months to five years, although some banks go up to ten years. You can buy bank CDs in denominations of $100 to $100,000 or more.
Although the bank will pay full interest if you hold the certificate until maturity, you can withdraw the funds sooner. But if you do, there will be early withdrawal penalties. However, the bank will usually refund your full principal amount.
Bank CDs are often recommended for balances below $250,000, as that is the maximum amount the FDIC will cover. (FDIC insurance coverage has a maximum of $250,000 per depositor, per bank limit, for all funds held on deposit at a single institution.)
Traded CDs
Traded CDs are bank CDs purchased by brokerage firms and other financial institutions (including financial planners, advisers, and consultants) and then resold to consumers. Since these are bank CDs, they are covered by full FDIC insurance of up to $250,000.
But because a broker can offer investors CDs from multiple banks and credit unions, investors can benefit from effectively exceeding the total FDIC limits of $250,000 while benefiting from insurance protection.
Because they are held in brokerage accounts, traded CDs can be bought and sold on the secondary market, just like stocks and bonds.
How do traded CDs work?
Traded CDs can be purchased as a new issue or on the secondary market in the case of existing certificates. Brokers find the highest rates, buy large amounts of each CD, then sell portions to consumers at slightly lower interest rates.
Traded CDs may have longer maturities than bank CDs. However, your money is not locked in and you can recover your funds by selling the CD in the secondary market through the broker at the then prevailing interest rate.
Brokers will set minimum investments, which can be $1,000, $10,000 or another denomination. And while interest on bank CDs is paid at maturity, brokers typically pay the interest earned on the CD monthly.
Brokers can earn commissions on traded CDs in two ways. The first is through an interest rate spread. In a typical example, the broker will offer CDs paying 2.00% to its clients at a rate of 1.75%. The 0.25% difference between the two rates is a commission for the broker.
The second scenario is a package. The broker may charge a very small fee per CD. It can be a flat rate of $1, $10 or another amount when you buy a CD up to a certain dollar amount. Or it can be a percentage of the CD purchase, like 0.10%.
Callable or non-callable CDs
Because brokerage firms sell them, traded CDs have provisions that bank CDs do not. Traded CDs can be either callable Where not callable. This is an important distinction you should be aware of before investing in a traded CD.
Callable CDs may require the issuing bank to terminate the CD before its maturity date. This can happen if interest rates drop to a certain point, usually below the rate on the CD. If the CD is redeemable, the bank will refund your original investment, plus any accrued interest, from the date the CD is called. If you’re considering investing in a traded CD, find out if it will be redeemable and if it’s a feature you’re comfortable with.
Non-callable CDs allow a fixed interest rate over the full term of the CD, ensuring that the CD will perform exactly as it was issued. This is the most predictable option since the bank cannot redeem the CD before maturity.
Are traded CDs risky?
When buying CDs, the main rule is to avoid risk. Most traded CDs are covered by FDIC insurance up to $250,000, making it easy to split multiple CDs between different banks.
However, if you invest in a CD for an institution that the FDIC doesn’t cover — and it does happen on rare occasions — you could lose your entire investment if the issuer goes bankrupt. Make sure the institution is covered by the FDIC; otherwise, don’t invest in the CD. The FDIC provides recommendations on what to look for when buying traded CDs.
The most common risk is that if you sell early, you may lose money. It all depends on the current interest rate on the secondary market. If you sell a CD at 2.0% when the current rate is 2.5%, you will likely sell the certificate for less than you paid.
Also be aware that selling a CD on the secondary market is not always easy. Unlike stock and bond markets, the secondary market for CDs is minimal. There may be no buyers for your CD if you want to sell it before it matures. This is more likely to be a problem if interest rates have risen since you invested in the CD.
Comparison of traded and bank CDs
Below is a summary of traded and banked CDs. This will help you get a clearer picture of how they work and the pros and cons of each.
Traded CDs
- Offered through a brokerage firm, financial advisor or financial planner who arranges the purchase of your CDs.
- Technically not insured by the FDIC, but the banks through which the CDs are issued are (or should be), and your broker or financial institution is responsible for confirming this.
- You may have to pay a fee to open a broker account, as well as a small fee for buying and selling each CD.
- With access to the vast pool of banks and credit unions offering CDs, you can get better interest rates than dealing with just one financial institution.
- Longer maturities are available on traded CDs, allowing you to take advantage of higher rates on longer terms.
- Traded CDs can be redeemable, which benefits the bank, but not you.
- Possibility of losing part of your investment if the CD is sold on the secondary market.
Bank CDs
- CDs will be limited to what is available at each location.
- Banks and credit unions rarely offer the highest rates on CDs.
- You must open your CD(s) at a bank or credit union.
- You are responsible for ensuring that your bank or credit union is FDIC insured.
- There is usually no charge to open a CD with a bank or credit union.
- The issuing bank or credit union guarantees your investment principal, and ultimately through the FDIC in the event of the institution’s bankruptcy.
- You will pay an early withdrawal penalty if you liquidate your CD before the stated maturity date.
- Interest earned on the CD will only be available at maturity.
- Interest rates are fixed for the duration of the CD.
Is a negotiated CD the right choice?
Traded CDs work best for investors with large investment portfolios. Since the FDIC insurance limit is $250,000 per depositor per bank, you will need to open CDs with four different banks to get full insurance on a $1 million CD portfolio. But you can buy multiple CDs from a broker, up to $250,000 per bank, and be fully covered by the FDIC.
In theory, you could invest $25 million in CDs at 100 banks, each fully FDIC insured.
Traded CDs also offer the possibility of earning higher interest than you earn at an individual bank or credit union. You can shop for banks and credit unions that pay the highest rates on CDs, but brokers offer a one-stop shop advantage. And since brokers actively search for the best paying CDs, you’ll be able to figure out where to invest your money quickly.
A negotiated CD can also allow you to lock in a higher interest rate for a longer term. While individual CDs from banks or credit unions often have terms of up to five years, traded CDs often have terms of 10 years or more.
The Basics of Traded CDs
Regular CDs purchased from a single bank or credit union will be more than enough to satisfy most investors. The big question they need to answer is whether a CD is the best investment given the limited growth potential.
On the other hand, if you’re looking for a CD but want to invest over $250,000 with the potential for higher rates, traded CDs are worth looking into.