Just When You Thought CD Ladders Were Dead …

CD ladders make less sense in the face of today's thin interest-rate spreads, but rising long-term rates may soon change things.
By Richard Barrington

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Low bank rates have made a mess of many conventional interest rate strategies, including CD laddering. But if CD rates start to follow recent interest rate trends in the bond market, CD laddering may soon make a comeback.

Should that happen, you should understand what obstacles have hindered CD ladders in recent years, and how changing conditions could make laddering more effective again.

The collapsing ladder

Laddering is a classic way to balance the liquidity of short-term CDs with the higher interest rates of long-term CDs. It involves spreading your money among CDs with different maturity dates. But the problem with laddering has been two-fold in recent years:

  1. Low interest rates make long-term CDs less desirable. Why lock in a rate for a long time when rates are more likely to rise than fall in the future?
  2. Long-term CDs have lost much of their rate advantage. According to FDIC figures, at the end of 2009 five-year CD rates had a 1.22 percent advantage over one-year CDs. By May of this year, that advantage was down to 0.53 percent.

With long-term CDs losing much of their appeal, the logical approach recently has been to shop for the best rates you can find at the short end, and maintain the flexibility to reinvest quickly should rates start to rise.

Raising the ladder again

The first weeks of May saw an interest rate trend that could restore the appeal of long-term CDs and make laddering more worthwhile. Intermediate and long-term bond rates have been rising, while short-term yields have continued to fall. This has strengthened the rate advantage of long bonds.

Should CD rates start to follow the same pattern, it may be worth considering some of the following techniques:

  1. The classic ladder. The most straightforward way to ladder would be to invest in CDs of varying length, say in yearly maturity increments of one to five years. This way, some of your money would be earning higher rates, while some would become available for reinvestment every year.
  2. Tilting the ladder. Laddering implies a regular series of CD maturities, but you do not have to divide your money evenly. You can tilt your laddering strategy according to your interest rate outlook. This would mean weighting short-term CDs more heavily if you think rates are likely to rise, and weighting long-term CDs more heavily if you think rates are likely to fall.
  3. Staggered start dates. Besides investing in CDs of varying lengths, another way to achieve a ladder is to invest all in long-term CDs but start those CDs at different times. Eventually, you could achieve the interest rate advantage of having all your money in five-year CDs, but achieve liquidity by having one of those CDs coming due every year.
  4. The penalty break. Since penalties for early withdrawal are generally based on a few months’ interest, those penalties actually become less onerous at low interest rates. So, one strategy is to look for long-term CDs with mild penalties, knowing that it may be worthwhile to incur the penalty if interest rates rise sharply.

The interest rate environment of recent years has reduced the number of options open to investors, so any sign that the direction of interest rates is changing should be welcome news. A comeback for the venerable CD ladder would be just one upside of this trend continuing.

About Author
Richard Barrington has been a Senior Financial Analyst for MoneyRates. He has appeared on Fox Business News and NPR, and has been quoted by the Wall Street Journal, the New York Times, USA Today, CNBC and many other publications. Richard has over 30 years of experience in financial services. He has earned the Chartered Financial Analyst (CFA) designation from the Association of Investment Management and Research (now the “CFA Institute”).