Is Callable CD a Higher Risk Investment?
Before you decide to invest on a callable CD, you should first understand what a callable CD is and how it could affect your investment plans. A callable certificate of deposit (CCD) is a certificate of deposit (CD) insured by FIDC. Hence, you have protection of the investment amount. However, callable CDs contain a unique call feature like other categories of callable fixed-income securities. The issuing banker holds the right to call away or redeem your callable CD before its maturity at a predetermined call price. The banker gets this calling right after a stipulated period, usually six months or one year after you purchase the callable CD.
Banks add this call feature to regular CDs to avoid payment of higher rates to the holder of the CD, if the interest rates drop in the financial market. Normally, banks redeem the callable CDs at a premium of the purchase price of the CDs to provide an incentive to the investor to take the risk of getting a higher return.
Why Banks Offer Caller CD?
Let us assume that you purchase a regular CD from a bank at an interest rate of 4.5% for 5 years and the interest rate drops to 3.5% in the market. In this situation, the bank would be forced to pay you an additional interest rate of 1% for the next two years also. If the bank induces you to buy a callable CD, then the bank would be able to redeem your CD and pay you a premium, which would always be lower than the 1% interest that the bank would be paying on your regular CD. Thus, the bank saves considerable amount by issuing a callable CD to you at 4.5%, redeeming it from you by paying you a small premium when interest rates drop and selling the CD to another person at the lower rate of 3.5%.
What is Your Position in Purchasing Callable CD?
When you purchase a callable CD, usually the bank offers you a higher yield than the yield on a regular CD. Hence, you have an advantage when you invest in a callable CD due to the higher yield. However, if the rates go down in the market, the bank would call the CD back and redeem it. You would be forced to invest that amount in a CD with a lower interest rate. On the other hand, if the interest rates go up, you are locked in an investment with a lower yield.
Hence, when you decide to purchase a callable CD, you are taking considerable risk. Callable CD is a purely speculative investment. You are an ordinary investor with limited financial knowledge. However, banks have enormous resources to analyze various financial returns and outgoes options. They consider several complex pricing models as their alternate options and decide on how you much they could offer you on your callable CD. Hence, it would be nearly impossible for you to beat them in this game. As such, it is better to stick to regular CDs or opt for variable CDs and avoid callable CDs unless you plan to invest for a very short period. A professional investment advisor would be able to give you proper advice on selection of the right callable CD.