Understanding the key features of the callable CD

A callable CD is a certificate of deposit which could be called away from the investor after the expiry of the call-protection period but before the maturity of the CD. For instance, a 5-year CD that has a 6-month call protection would be callable after 6 months.

The callable CDs are offered by banks to shift the interest rate risk to the investor as the investor is taking on this interest rate risk. However, a callable CD will have a much higher yield when compared to a regular CD with the same maturity date. This additional yield is offered to the investor for investing in the CD despite the interest rate risk.

The interest rate risk means that the rate of interest would move during that time period that you hold the investment. For the banks however, the interest rate risk means that the interest rates go down and they could have issued the CD at those low interest rates if they had to wait. For the investor it means that the interest rates increase and by waiting they could have purchased the CD at higher interest rates. Both sides want to gain out of this interest rate risk.

Banks cleverly manage their exposure to the interest rate risk by selling the callable CDs. There is a complex calculation that goes into how much the banks are willing to pay the investor to purchase the callable CD as against the non-callable CDs. All the analysis is done as they are the ones managing the exposure to the interest rates on their loan portfolio as opposed to the interest rate exposure on the deposits.

While the banks are hedging their interest rate risk, it is the investor who is speculating with the callable CD. Typically the investor just offers a glance between the differences in rates between the two CDs and decides if the investment in a callable CD is worthwhile.

The most undesirable aspect of the callable CD is that if the interest rates go lower the CD gets called and the depositor will have to reinvest with the lower interest rate that prevails.

Callable CDs are right for you, if you are looking for better yields with limited risks as these are also FDIC insured. However, it is better to read the fine print and be aware of the facts before turning your money in to some bank or a brokerage firm. Otherwise this could lead to huge disappointments.

The change in the existing interest rates is the main reason for the brokerage firm or the bank to call the CD. Hence, you must think before investing in the callable CD as the interest rate risk will be shifted on to you. Always compare the rates of the two CDs that are the traditional CDs or the callable CD and check to see which way the interest rates are likely to head in the future. If you are worried about the reinvestment risk and prefer to avoid the hassles, then the callable CDs are certainly not for you.