If you’re looking for a low-risk, high-yield investment option, certificates of deposit, or CDs, may be a good choice. They are typically insured up to $250,000 (per depositor, per institution) by the Federal Deposit Insurance Corporation and can beat out traditional savings rates. CDs are unique because you commit to an investment term in which you won’t withdraw your money. In exchange, you get a better yield with minimal risk. Generally, the longer the CD term, the higher the rate. But currently, short-term rates are higher than longer ones because of an inverted yield curve.
[Read: Best CD Rates.]
What Is a Yield Curve?
A yield curve is a graph that shows how interest rates change as the term of a debt (like a bond) increases or decreases.
“The U.S. Treasury yield curve is simply a graph showing the relationship between the yield on a U.S. Treasury security in relation to the maturity of the instrument,” says Robert R. Johnson, a chartered financial analyst and professor of finance at the Heider College of Business at Creighton University. “Most often, the yield curve is upward sloping. In other words, longer-maturity [U.S.] Treasury bonds have a higher yield to maturity than shorter-maturity [U.S.] Treasury bonds.”
In a normal yield curve, investors get rewarded with higher rates for taking on the extra risk associated with a longer-term CD. After all, many variables affect interest rates, and the economy can change a lot over time.
An inverted yield curve flips things, leading to higher interest rates in the short term rather than the long term.
Why an Inverted Yield Curve Matters
An inverted yield curve typically occurs before a recession, according to the Federal Reserve Bank of Chicago. As of July 2024, market conditions don’t point to a recession. But an inverted yield curve can signal economic uncertainty and more risk.
When there is an inverted yield curve, short-term rates offer a greater return than longer-term ones. This can affect the annual percentage yield, or APY, you get on CDs.
[See: Best High-Yield Savings Accounts]
How an Inverted Yield Curve Affects CDs
To illustrate how an inverted yield curve affects CDs, take a closer look at these real-life CD interest rates. At the time of publication, Capital One is offering a one-year CD with a 5% APY. CD interest rates for a two-year term drop down to 4% APY, and the five-year APY is 3.90%.
Ally Bank offers nine-month CDs with an APY of 4.85%, while its five-year CD has an APY of 3.90%. The pattern is clear – instead of longer-term CDs paying more (the normal yield curve), rates are actually better for shorter-term certificates. You won’t earn extra interest for tying up your money longer.
How CDs Work as Investments
CDs allow you to invest a sum of money for a specific term. There may be a minimum initial deposit of $1,000, but not all financial institutions have minimum requirements. CDs aren’t like savings accounts in which you deposit or withdraw money whenever you want. Instead, your funds can be locked up for three months to more than five years.
You agree not to access your money before the CD term is up. Doing so will trigger a withdrawal penalty, which means you have to give back seven to 365 days of interest, depending on the CD term and the institution’s policy. If you stay the course, you can access your money and the interest earned when your investment reaches its maturity date. Once your CD matures, you can use your money or reinvest it into another CD.
The Benefits of Investing in CDs
The benefits of investing in CDs include:
— Higher interest rates than traditional savings accounts
— Forced savings because you can’t easily withdraw
— Extremely low-risk
— A variety of term lengths available
How to Invest in CDs
Figuring out how to invest in CDs and being strategic with the term length can help you reach your savings goals.
“What are you trying to do with your money? If you don’t know what your goal is, then any investment might do,” says James Martielli, certified financial analyst and head of investment and trading services at Vanguard.
For example, you may know that you want to take a big vacation with the family in one year, or you’re planning to make a down payment on a car. You have the money, so putting it in a one-year CD may be a smart idea.
To help you decide the term length, Martielli says it’s important to know your timeframe and what you want out of the investment. “If you have a shorter time horizon, you might want to think of your time horizon for CD maturity to be somewhat similar,” he adds.
How to Invest in CDs During a Yield Curve Inversion
Given the inverted yield curve, how can you take advantage of high short-term rates but also prepare for the longer term? A CD ladder can be a good strategy.
“CDs may be laddered in maturity dates to manage interest rate risk. As opposed to bonds and common stocks, which are typically considered longer-term investments, CDs may be purchased with securities that match investors’ short-term needs,” says Johnson.
To create a CD ladder, you can take a sum of money and choose to invest in multiple CDs with different term lengths. Typically, you would divide the amount of money equally. So for example, if you have $20,000 to invest in CDs, a CD ladder might look like this:
[Read: Best Savings Accounts.]
The ladder approach ensures you can access money faster in the shorter term and take advantage of the current inverted yield curve while locking in rates for the long term as well.
“As the Fed lowers rates, expect CD rates to follow. What this means for CD investors is that if the consensus of market participants is correct, investors should lock in longer-term CD rates today, as the expectation is that they will be lower in the near future,” says Johnson.
Using this approach, be aware of your maturity dates. Some CDs may automatically renew. While you can withdraw the funds when CDs mature, many people using the CD ladder strategy to reinvest the money in a new CD.
While a CD ladder strategy can be a smart option to manage risk and fluctuating CD interest rates, make sure you have an emergency fund in a high-yield savings account for easy access.
CDs Offer Safety in any Economy
Investing in CDs can be a secure bet whether there’s a normal yield curve or an inverted yield curve. However, many personal finance advisors recommend that you diversify into other types of investments as well. Though higher CD interest rates can be appealing, don’t lock up your money if you don’t understand your “why.”
Staying focused on your goals, time horizon and risk tolerance can help you in the short term and long term.
“Try not to let the noise of the market sway you off course,” says Martielli.
More from U.S. News
What Is a Good Interest Rate on a Savings Account?
Why You Shouldn’t Dump Your Brick-and-Mortar Bank
The Average Savings Account Balance
How to Invest When Short-Term CDs Are Higher Than Long-Term CDs originally appeared on usnews.com
