A certificate of deposit (CD) is a time deposit account that earns a specified interest rate and expires on maturity date. CDs have typically higher returns than savings accounts and offer a relative protection to the beneficiary against market fluctuations. This is why they are mostly preferred from risk-averse investors, who want to maintain their capital and calculate expected returns on maturity.
On the other hand, by investing on CDs, investors get a higher interest rate on their money, but if market conditions change, they possibly miss an opportunity if the prevailing interest rates in the economy increase over the period of the CD. Therefore, savvy investors structure their certificates of deposit using certificate deposit ladders to mitigate fluctuating interest rates.
With a CD ladder, investors distribute their money over a period of several years aiming to have their money deposited at the longest term. In doing so, a portion of the invested money matures annually and it can be reinvested over a longer period of time. For instance, an investor that invests today $6,000 in a CD and wants to roll it over a three year CD ladder would invest $2,000 in a 3-year CD, $2,000 in 2-year CD and $2,000 in 1-year CD. After three years, he would have all the money deposited back at the three year rate. Thus, the investor takes advantage of the longest term interest rates and has the option to reinvest the money or withdraw it in short term intervals.
Example
We assume that the interest rates of bank X for certificates of deposit are the following:
3-month: 1.25%, 6-month: 1.65%, 9-month: 1.60%, 12-month 2.10%, 2-year: 2.40%, 3-year: 2.75%, 4-year: 2.90%, 5-year: 3.40%.
We also assume that an investor wants to roll over a period of 5 years $20,000 into certificates of deposit. Since the longest term he wants to set is 5 years, it is proper to split $20,000 evenly at $4,000 per year. Since the shortest maturity given by the bank is 3 months, it is proper to split $4,000 evenly at $1,000 per quarter. At the end of the first three quarters, the investor will withdraw each quarter’s $1,000 plus interest rate and will use the money to buy new 5 year CDs.
Therefore, in Phase One, the investor sets the CD ladder as follows:
$1,000 in a 3-month CD
$1,000 in a 6-month CD
$1,000 in a 9 month CD
$4,000 in a 12-month CD
$4,000 in a 2-year CD
$ 4000 in a 3-year CD
$4,000 in a 4-year CD
$1,000 in a 5-year CD
After year one of rolling the money like this, the investor has
$4,000 maturing today (original 12-month CD)
$4,000 maturing in one year (original 2-year CD)
$4,000 maturing in two years (original 3-year CD)
$4,000 maturing in three years (original 4-year CD)
$1,000 maturing in four years (original 5-year CD)
$1,000 maturing in fours years, three months (original 3-month CD reinvested)
$1,000 maturing in fours years, six months (original 6-month CD reinvested)
$1,000 maturing in fours years, nine months (original 9-month CD reinvested)
With the $4,000 maturing today, the investor can buy:
$1,000 in a 3-month CD
$1,000 in a 6-month CD
$1,000 in a 9 month CD
$4,000 in a 5-year CD
The investor can do the same with every $4,000 that matures annually until he get 20 CDs maturing each quarter over the next five years. Then, he can choose either automatic renewal or to withdraw the money.
CD ladders are a systematic approach to investing that protects investor against market fluctuations. Although, by constructing a CD ladder, the investment is spread over an investment horizon that picks the maximum maturity and in-between maturities over the period of investment, investors are locked in a way. The logic of a CD ladder is to buy a new long-term certificate of deposit every time a CD matures in order to get a higher average return than what trying to timing the market would give. However, investors lock in a long-term certificate of deposit and roll their money until maturity. In case they decide to withdraw the money before maturity, a substantial penalty incurs for early withdrawal. If interest rates are on the uptrend, it’s easy to invest large amounts at each rate knowing there is potential to buy at a higher rate when the next CD matures. But, if interest rates decline, investors feel trapped in their own money as they can put only a fraction of their money in such low rates.
Another drawback of a CD ladder is that investors put a lump sum upfront and initial returns depend on the interest rates while constructing the ladder. If the market conditions are like today, with yields on maturities rather flat, investors do not really get any additional returns from investing in longer maturities and constructing a CD ladder may not be advisable.