4 Factors to Consider When Choosing A CD Term

Certificates of Deposit [CDs] are often valuable additions to a business cash management plan because of their high returns compared to alternatives and government backing through the FDIC or NCUA. However, these advantages come with a trade-off – liquidity is constrained by the CD’s term.

The term of a CD determines when the business can access their cash without a penalty, so choosing the correct term is a vital decision. The right term structure for a company should balance maximum returns with financial flexibility. To find this balance, consider the following factors before investing.

1. Liquidity Needs

Arguably, the most crucial factor for a business in determining a CD term is projected cash needs. Funds invested in a CD are generally inaccessible before maturity without incurring an early withdrawal penalty. This penalty typically involves forfeiting a portion of the accrued interest, and in some cases, even a portion of principal.

Before choosing a CD term, cash managers should conduct a thorough analysis of cash flow to determine the schedule on which the funds will be needed. This analysis should include predictable cash needs – like operational expenses and planned capital expenditures. It should also include additional reserves for unexpected expenses.

Funds that may be needed in the short term to meet regular or emergency needs may be good candidates for short-term CDs or a CD laddering strategy. Conversely, cash that is not needed for several years could benefit from longer-term CDs when they have a higher yield.

Weigh The Benefits of Interest Against Potential Early Withdrawal Penalties for Emergency Cash

Early withdrawal penalties are typically expressed in a certain number of days or months of interest to be forfeited if the funds are withdrawn before the end of the term. The penalty can vary between CDs, so it is important to review the investment literature before determining if a CD is the right investment for emergency cash.

2. Current Interest Rates and Expectations

The prevailing interest rates also play a significant role in CD term selection. These rates are influenced by inflation, economic growth, and monetary policy decisions by the Federal Reserve.

When interest rates are rising or are expected to rise, businesses may prefer short-term CDs. This allows them to reinvest funds at higher rates when their current CDs mature and avoids being “locked into” a low interest rate for an extended period.

Conversely, during periods of falling interest rates, “locking in” the current interest rate can be advantageous. This strategy protects the business when rate cuts occur and enables above-market returns throughout the duration of the CD or until rates recover.

During periods of stable interest rates, their projected path is a less substantial consideration. Instead, cash managers would focus on the shape of the yield curve to determine the optimal return on their CD.

Yield Curve Shape

The yield curve is a graphical representation of the relationship between interest rates and the time to maturity for term investments of similar credit quality. A “normal” yield curve slopes upward, meaning longer-term CDs have higher yields than short-term CDs. This is considered “normal” because investors generally expect to be compensated for increased inflation risk and opportunity cost when they are locked into an investment for a longer period of time.

In some cases, the yield curve can invert, where short-term rates are higher than long-term rates. This often occurs when there is significant economic uncertainty or the risk of an impending recession. In these scenarios, short-term CDs may offer competitive or even superior yields when compared to longer-term alternatives.

The yield curve changes constantly based on the markets. View the yield curve based on the most recent closing data here.

3. Inflation Rate and Expectations

Inflation erodes the purchasing power of money over time. When considering CD investments, cash managers should include this erosion in their calculations. This can be done by calculating the real rate of return, which is the nominal interest rate minus the inflation rate over a consistent time period.

If a CD’s real rate of return is negative, then it may not be a wise investment since the value of the cash being invested will decline over the term of the CD. This occurs when the interest rate is lower than the inflation rate over the same period.

4. Opportunity Cost

The final piece of the puzzle when determining an optimal CD term is opportunity cost. In other words, what is the cash manager giving up to invest in the CD?

To determine the opportunity cost, a cash manager should review other investment options to determine how much interest they could earn. As they do this, it is important to consider the risk of each potential investment as well as the potential gains.

Strategies for Optimizing CD Investments

After considering these factors, businesses can employ several strategies to optimize their CD investments. One of the most popular of these strategies is CD laddering.

A CD ladder combines the benefits of both short- and long-term CDs into a single strategy. It involves dividing the total investment amount into several CDs with staggered maturity dates. The business then has the option to either access the funds or reinvest them in new CDs as they mature. In this way, they continually “roll over” the ladder, providing regular liquidity while allowing a portion of the funds to earn higher, long-term rates under normal yield curve conditions.

Another strategy is to invest in the longest-term CD possible that aligns with liquidity needs. This is beneficial for funds earmarked for specific projects or large purchases in the future. By investing in a long-term CD, the business gains the opportunity to earn the highest yield under normal yield curve conditions.

These strategies are beneficial when interest rates are stable and yield curve conditions are normal. However, when the yield curve is inverted or interest rates are expected to change dramatically during the investment term, adjustments may need to be made. A company that specializes in business cash investments can be a crucial partner in determining the optimal CD strategy and adjusting it to match market conditions.

Maximize Business CD Investments With ADM

At American Deposit Management, we have spent over fifteen years helping businesses manage their CD investments. Our team has the experience to help cash managers weigh their options and choose a CD strategy that provides the long-term interest they need while preserving appropriate liquidity.

Our patent-pending technology utilizes our network of banks and credit unions to provide access to full FDIC or NCUA insurance – even for CD funds far exceeding the traditional limit. Our clients also have access to exclusive CD rates from the financial institutions in our network, which often vastly exceed the rate they could earn at a local bank.

To learn more about our CD solutions, contact a member of our team today.

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