OCEAN CITY – When credit becomes noticeably tighter, as it is in today’s economy, meeting your cash flow needs can require a little more planning than usual. More than ever, dealing with life’s expenses — both planned and unexpected — calls for a strategy that gives you the flexibility you need without disrupting your larger investment goals.
One part of a strategy that can keep you positioned for growth while offering you liquidity — in other words, the ease with which investments can be converted into cash — could be CD laddering. When you purchase certificates of deposit with staggered maturities, as each CD matures you can use the proceeds for your expenses or reinvest it as you choose.
“For the investor, the CD ladder can be an excellent way to achieve yield objectives in the safety of an FDIC-insured vehicle while riding out the recent volatility,” says David Hargarten, Managing Director of Cash Management Solutions, Wealth Management Banking at Merrill Lynch. “This structure also affords an investor recurring access to cash to take advantage of either alternate opportunities when they arise, or addressing cash needs.”
CD laddering is also becoming more attractive as the market slowly rebuilds confidence in longer-term investments. Explains Hargarten, “Recently, the yield curve has steepened—that is, the difference in yield between long- and short-term rates. I believe this presents an excellent opportunity for buyers to lock in rates at the longer end of the ladder, which can improve a ladder’s overall yield.”
Among the advantages of CDs are that they offer government insurance, guaranteed yield and a variety of maturities. Because they are classified as bank deposits, CDs are FDIC-insured—and the federal government in October increased the insurance limit from $100,000 to $250,000 per account. It’s important to note that the limit applies to all of an individual’s deposit accounts at a given bank; even though a single CD might be valued at less than $250,000, your total with savings accounts or other deposits could exceed the limit, leaving some assets without coverage. Also, Congress recently extended this provision through Dec. 31, 2013, a factor worth keeping in mind when considering purchases of longer-term CDs.
On the other hand, CDs do have limitations. One of the primary ones is that they limit your access to capital for the term you’ve chosen, potentially curtailing your access to higher interest rates. However, this disadvantage can be mitigated by taking advantage of tiered maturity dates. “Distributing CD purchases over a variety of maturities helps hedge the risk that rates will move up after you’ve invested,” Hargarten says.
Say, for example, you decide to set aside $500,000 to place in secure cash instruments, with the objective of receiving FDIC insurance as well as income. Purchasing a single five-year CD for the total amount would have drawbacks. To begin with, limits on FDIC insurance mean you would have federal protection for just half of your deposit. In addition, committing to a five-year maturity would increase your risk of opportunity cost—in other words, the chance to invest the same money elsewhere with the potential of higher gains (along with greater risk, of course). Because the five-year CD is locked into a set yield for that period, you would miss the chance to boost returns if interest rates were to rise. And if you needed to cash out the CD prematurely for any reason, you might pay an early withdrawal penalty.
In an instance like this, CD laddering could be a smart option. You might purchase five separate $100,000 CDs from three different banks, at maturities ranging between one and five years. Rather than waiting the full five years to have any access to your principal, you could receive a portion of your money each year, as the appropriate CD matured. You would then have the choice between putting those returns into a new CD with a competitive interest rate, using the money to meet expenses or reducing your portfolio’s cash component by investing elsewhere.
Anyone considering such a strategy should be aware of several points regarding its use. For one thing, it requires a degree of ongoing attention to keep track of the varying maturities. One of Merrill Lynch’s dedicated wealth management bankers can help you and your financial advisor set up and maintain your laddering strategy. Even more important from an investment standpoint: No matter how well you execute this strategy, CDs can’t by themselves sustain a portfolio’s more ambitious objectives or replace assets devoted to long-term growth. As with most conservative strategies, overinvesting in CDs can hurt your portfolio’s long-term growth potential.
“The CD ladder as an allocation within an overall portfolio will be dictated by the investor’s age, risk tolerance and time horizon because, as with any investment, there’s a risk/reward trade-off,” Hargarten says. “By investing in a CD ladder, an investor may be sacrificing higher yields available in alternative vehicles.” He recommends that investors instead look for a balance between security and growth, short-term investments and larger goals. “It’s a matter of working with a Financial Advisor to find the allocation that fits you.”
(A Merrill Lynch Senior Financial Advisor. She can be reached at 410-213-8520.)