Earlier this month, the Federal Reserve issued its third interest rate hike in the past six months. Since the recession of 2008, the Fed has kept interest rates historically low in an attempt to stimulate the struggling economy.
But now that the economy is on the upswing and interest rates are back on the rise, stock investors may soon have more options to earn relatively safe returns on their cash. One of those options that has been off the table for nearly a decade is the bank certificate of deposit, or CD.
The eight-year bull market for U.S. stocks may still have room for upside, but investors concerned about steep stock valuations have plenty of reasons to be skeptical of stocks.
[Read: How to Create a Retirement Investment Strategy.]
The cyclically adjusted price-earnings ratio of the Standard & Poor’s 500 index stands at 29.8. CAPE is a variation of the popular P/E ratio that incorporates 10 years of earnings data to smooth out cyclical economic fluctuations. The lower the ratio, the more earnings power investors are getting for every dollar they spend on stocks.
The mean historical average CAPE of the S&P 500 is 16.7, and it has exceeded 30 only twice — prior to the Black Tuesday market crash in 1929 and prior to the bursting of the dot-com bubble in 2000.
But for uneasy investors that want to pull money out of pricey stocks, having that cash sit unused is not a great investment strategy. In fact, unused cash is actually depreciating in value due to inflation at a current rate of around 2 percent per year.
Prior to the recession in 2008, Americans were able to earn more than 3.5 percent interest on certificates of deposits, or CDs, with minimal risk to their accounts.
A certificate of deposit is essentially a bank savings account on steroids. In exchange for a higher interest rate than the typical bank savings account, investors are restricted from accessing their funds for a set time period, typically one to five years. The longer the term of the CD, the higher the interest rate investors earn.
For example, Goldman Sachs recently raised the interest rate it pays on standard savings accounts to 1.2 percent. For a 12-month certificate of deposit, Goldman currently offers 1.39 percent. By committing to a one-year term, Goldman’s customers can earn an extra 0.19 percent in interest. Of course, by committing to a five-year CD, Goldman customers can earn an even higher interest rate of 2.23 percent.
[See: 7 Stocks to Buy for the Baby Boomer Retirement Wave.]
CDs are not like stocks or other investments that allow investors to adjust positions on a daily or weekly basis. In order to access CD funds prior to the end of the CD’s term, an investor will be forced to pay an early withdrawal penalty that typically ranges in size between three and six months worth of accrued interest.
CDs are one of the lowest-risk ways to earn returns on cash. Like standard savings accounts, CDs are insured by the FDIC for up to $250,000 per person per insured bank.
For investors, 1 to 2 percent interest rates are nothing to get excited about, but that’s where the Federal Reserve comes into play. As the Fed continues to raise the fed funds target rate, CD rates should theoretically continue to rise as well.
As recently as the 1990s, CD rates were above 5 percent. While investors shouldn’t expect rates to return to that level anytime soon, savers and nervous stock investors should keep an eye on CD rates in the coming years.
“Rates are now at the point where CDs start to become worth a look,” says Brad McMillan, chief investment officer for Commonwealth Financial Network. “With inflation as low as it is and with other options being potentially riskier, a CD could be a good option for certain investors.”
Older investors who consider risk management to be a top priority may find even the modest yields that CDs currently offer an appealing option, says Mike Loewengart, vice president of investment strategy at E-Trade.
“While the mass appeal of CDs has waned in recent years, they never became irrelevant to an important and growing demographic — retirees,” Loewengart says. “Who knows what the future will bring, but having a guarantee of even a modest return may be the antidote for those who don’t have an appetite for volatility.”
[See: 10 Long-Term Investing Strategies That Work.]
Owen Murray, director of investments for Horizon Advisors, says it’s still too early for CDs to appeal to even most retirees just yet.
“Although CD yields have improved, they remain well below historic norms,” Murray says. “After adjusting for inflation, there still isn’t any real value created by owning CDs at today’s low yields.”
For retirement-age investors looking for safe, reliable yield, there are limited options available. However, investors looking to diversify away from the stock market and into less-volatile alternatives on a one- to five-year time frame can choose CDs over cash as a way to at least protect their savings from inflation.
But if the U.S. economy stays on the right track and interest rates continue to rise in the years ahead, CDs may once again become an appealing option for investors of all ages for the first time in nearly a decade.
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Why a Certificate of Deposit Is a Safe Investment originally appeared on usnews.com
