CDs and Other Short-Term Investments

by Rob Williams, Director of Income Planning, Schwab Center for Financial Research
Updated February 13, 2009

When investors place their money in certificates of deposit (CDs), they're generally looking to invest their cash for a set period of time and with a guaranteed rate of return.

CDs score fairly well on several points—they're widely available, pay fixed rates of return that are currently beating Treasuries or savings accounts, and are FDIC-insured up to certain limits.

You're protected from loss by the U.S. government up to $250,000 per issuing bank for CDs maturing before December 31, 2009. After that date, coverage is currently scheduled to revert back to $100,000 after recent amendments to the FDIC guarantee expire. If you have more cash to invest than covered by these limits, you can hold CDs from multiple banks, each up to the FDIC limit, in a single Schwab brokerage account.

Banks compete with each other to offer competitive CD rates, so rates will vary. Right now, average rates generally exceed Treasuries for equivalent maturities. For a look at current CD rates, as well as rates for other fixed-income investments, log in to your Schwab account, then click the Trade tab. Rates increase with maturity, from one month up to 10 years.

One weakness, however, is liquidity. Once you purchase a CD, it's generally more difficult to sell than some other short-term investments, or you may be required to pay a penalty should you need the cash before the CD matures. So, you might not be able to get immediate access to your cash if you need it.

If you have a very specific timeline in mind and value certainty of return, a CD can be an attractive short-term investment. However, there are other options you might consider, as well.

Sweep, savings accounts and high-yield checking
CDs have generally served as alternatives to traditional savings accounts, attractive because they generally pay a higher interest rate for funds you don't need access to on a day-to-day basis. But sweep, savings and interest-bearing checking accounts can be more appropriate if you need easy access to your cash.

The returns, however, can be quite low, so they tend to serve more as cash-management tools than competitive investments. They're good, secure places for day-to-day cash, but not as ideal for a bit of extra return.

CDs and sweep, savings and high-yield checking accounts are generally considered bank products: A bank (as well as FDIC insurance, up to the limits) commits to return the full amount of your principal, plus interest. There are a variety of other investment vehicles that might be suitable alternatives to CDs for competitive returns, as well.

Purchased money-market funds
Purchased money market funds are mutual funds that hold short-term investments, often Treasury bills, but also often other short-term investments, like government agency notes, commercial paper, bankers' acceptances, variable-rate notes or, for tax-exempt funds, short-term municipal notes. Their returns will vary, as will their strategies. Some limit themselves to Treasury bills, while others extend their investments to other non-government securities. Read the fund prospectus for specific investment guidelines.

All money market funds are restricted by the Securities and Exchange Commission's Rule 2a-7, which limits investments to shorter-term maturities, certain credit ratings and limitations on exposure to an individual issuer or security. Funds that pursue more expansive strategies, within these constraints, do so in an effort to generate slightly more competitive returns. Those limited to Treasuries alone actually are having trouble generating positive returns at all—yields on short-term Treasuries are now at record lows.

Regardless of strategy, money-fund managers commit to maintain the value of your investment at a steady $1 in net asset value (NAV) per share—100% of your original investment—if there is a loss or change in value of the securities it holds. Recently, however, some funds have been forced to "break the buck,"—that is, they were unable to maintain their commitment to maintain the $1 in NAV.

Despite these recent stresses, most funds tend to hold conservative investments—especially now, after the recent market stress—with the ultimate goal of retaining their commitment to return investor principal on demand. For cash invested before September 19, 2008, funds that have chosen to participate are protected by the Treasury's Guarantee Program, as well.

If you're most concerned about safety, you might still opt for funds limited to government-agency securities (including, but not limited to, Treasuries), keeping in mind that there may be a trade-off in return, as well. Cash received from purchased money market funds can be accessed quickly—the next day if sold before 4:00 p.m. ET.

Treasury bills or notes
For security of principal, there are few investments considered more certain than Treasuries—they're issued as bills (mature in one year or less), notes (two–10 years), or bonds (10–30 years). If you hold to maturity, we believe you're likely to receive your principal in full.

But the returns right now are quite low—well below comparable CDs. Recently, Treasuries have seen a flood of capital from those seeking safety, which is driving prices up and pushing yields down. Should this trend reverse, the price of existing Treasuries could drop. While this wouldn't be of concern to investors who plan to hold to maturity, investors wanting to sell beforehand—Treasuries, unlike CDs, are highly liquid and easy to sell—may have to sell at a lower price.

Individual short-term bonds
There are a variety of other short-term bond types that can be purchased as alternatives to CDs, including (in order of relative risk) U.S. government-agency securities, and municipal, and corporate bonds. The level of security, however, can vary based on the individual issuer, credit rating and other factors. Consider your objectives if you do opt to move out slightly on the risk spectrum in pursuit of yield. Are you seeking safety and a liquid place to hold short-term cash? If so, individual short-term bonds or funds may not be your best option.

If you're concerned about quick return of cash, look for shorter maturities—the date that a bond matures, repaying its principal—much like the term on a comparable CD. Keep in mind, however, that their prices can change depending on market conditions. Immediate liquidity at a particular price is not guaranteed, particularly if there are credit concerns about a particular bond or issuer.

Also know that short-term bonds, notes or bills with higher risks generally pay higher interest rates. For bonds with higher yields, there may be good reasons. The higher the yield, the higher the market's sense of these risks. As a result, diversification becomes more important. We don't recommend tying up all of your cash in just a few individual short-term bonds.

Short-term bond funds
In contrast to individual short-term bonds, bond funds can provide liquidity, competitive returns and the benefits of diversification. The returns—which are paid in the form of fund dividends, often monthly—can be relatively consistent, but not as certain as an individual bond held to maturity. The value of the fund will fluctuate, as well. This has been especially true lately, given recent credit markets, as bond funds have been forced to assign a value to the bonds they hold now that are often below the original purchase price.

Funds that focus on shorter-term investments have generally fluctuated less in value, although their yields are generally lower, as well. Municipal bond funds, unlike CDs, also benefit from dividends that are exempt from state and federal income tax. None of these should be viewed as a substitute for cash, an insured CD, or bank account for ultimate security. But these alternatives may be worth considering if you're looking for a bit of additional return, as well as liquidity, in a portion of your investment portfolio.

For additional insight on bonds versus bond funds, see "Bonds or Bond Funds?" For a list of funds to consider, as well as their recent dividend returns, see the short-term bond section of Schwab's Income Mutual Fund Select List.

As always, if you have questions or need help, please contact your Schwab consultant. If you're not yet a Schwab client but would like to learn more, a Schwab consultant can help. Call 800-435-4000 to get started.

Important Disclosures

The U.S. Treasury Temporary Guarantee Program provides a guarantee to participating money market mutual fund shareholders based on the number of shares invested in the fund at the close of business on September 19, 2008. Any increase in shares in the account after the close of business on September 19, 2008, will not be guaranteed. If the value of these shares fluctuates over the period, investors will be covered for either the number of shares held as of the close of business on September 19, 2008, or the current amount, whichever is less. The Program expires on April 30, 2009, unless extended by the U.S. Treasury.

Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

The current and future portfolio holdings contained in a mutual fund is subject to risk you should be aware of prior to making an investment decision. Past performance is no guarantee of future results, and your investment value and return will fluctuate such that shares, when redeemed, may be worth more or less than original cost.

An investment in a money market fund is neither insured nor guaranteed by the FDIC or any other government agency. Although the fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in the fund. Please note that bank deposits are FDIC insured up to $250,000 while nonbank independent products have no such guarantees.

Certificates of deposit are offered through Charles Schwab & Co., Inc. CDs from Schwab CD OneSource are issued by other FDIC-insured institutions, and are subject to change and system access. Unlike mutual funds, certificates of deposit offer a fixed rate of return and are FDIC-insured. There may be costs associated with early redemption and possible market value adjustment.

On October 3, 2008, FDIC deposit insurance temporarily increased from $100,000 to $250,000 per depositor through December 31, 2009. IRAs and certain other retirement accounts for which the deposit insurance limit already was $250,000 prior to October 3, 2008 will continue to be insured up to $250,000. CDs with a maturity date after December 31, 2009, which had an insurance limit of $100,000 prior to October 3, 2008, will temporarily have an insurance limit of $250,000, but will revert to the $100,000 limit after December 31, 2009. The FDIC considers any other deposits you may have with an issuing bank. CDs you purchase from a particular bank are aggregated with any other deposits you may have with the issuing bank for determining FDIC insurance coverage.

Fixed income investments are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, corporate events, tax ramifications and other factors.

When a bond is purchased or sold, Schwab charges a commission, markup or markdown. Individual bonds are subject to the credit risk of the issuer. Changes in interest rates can affect a bond's market value prior to call or maturity.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, financial planner or investment manager.

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