Fixed callable CDs as investments – looking beyond the rate

By David Savoie, President/CEO, LaCorp

With most analysts forecasting a decline in interest rates at some point in the near- to medium-term, Fixed Callable CDs can be attractive investment options. But if your credit union hasn’t purchased them in the past, you might not be familiar with the terminology. However, once you understand it, fixed callables (FCs) can be a great investment option. 

The basic idea behind fixed callable CDs is that you, as the investor, get paid a higher rate than you would on a non-callable CD of the same term. For example, a 2-year regular bullet maturity CD that yields 4.50%, might yield 4.75% as a callable CD. The 0.25% additional yield is called a call premium.  That is the additional amount you get paid as an investor for accepting the risk of a call option. The call option gives the issuer, not the investor, the right to mature the investment early on specified dates. 

The next term you need to know is the lockout period. The lockout period is the time after issuance in which the issuer cannot call the CD. Throughout the lockout period, you are guaranteed to get the initial rate. In a period of declining rates, this can be an above-market rate, which makes FCs a strong option if rates are declining or if you expect rates to decline. So, in a period of declining rates,  FCs with shorter lockout periods will yield more than those with longer lockout periods.

The terms of a fixed callable CD are described in a shorthand called notation that can look like Greek but is easy once you understand it.  Let’s look at a few examples:

2nc1yr continuous 5.00%

This is a 2-year fixed callable CD yielding 5.00%. It has a one-year lockout period, abbreviated as nc1yr or “no call 1 yr.”  After the end of the one-year lockout period, it can be called at any time, which is known as a continuous call. Keep in mind that the issuer makes call decisions based solely on the math: If rates decline and they can issue new CDs at a lower rate than the 5% for the same term, they will call the CD. At that point, you would need to reinvest the proceeds at what would be a lower rate. What you received in return for this disadvantage is a higher rate for the 1-year lockout period than you would have otherwise received on a non-callable bullet maturity CD.

3nc6mos quarterly 5.375%

This is a 3-year fixed callable CD yielding 5.375%. It has a 6-month lockout period, “nc6mos” or “no call 6 months.” After 6 months, it can be called at the end of each quarter thereafter. It can only be called on the quarter-end dates, not in between. These are known as discrete call dates. 

3.5nc2yr one-time 4.625%

This is a 3.5-year fixed callable CD yielding 4.625%. It has a 2-year lockout period, “mc2yr.” One-time means it can only be called on one specific day, the 2-year anniversary of issuance. If it is not called on that date, it will not mature until the end of the 3.5-year term. 

Comparing Fixed Callables

The key point to remember in comparing fixed callables is that for CDs of comparable maturities, the shorter the lockout period, the higher the yield. Although the higher yield can be attractive on a short lockout period, keep in mind that in a period of declining rates, the shorter lockout period means you will enjoy that better rate for a shorter period of time. 

What’s a Puttable CD?

Puttable CDs are the opposite of Callable CDs. Although not seen very often in the market, understanding puttables helps to understand the mechanics of Callable CDs. In a puttable CD, the purchaser (you) has the option of cashing in the CD early, not the issuer. You “put” the CD back instead of the issuer “calling” it back from you. Because the issuer is taking the risk of you redeeming the CD early if rates were to go up, a puttable CD yields less than a non-callable CD of the same term. This is called the put discount, the opposite of the call premium.

The main takeaway here is that at a time like this when declining rates are expected, the higher yield on a fixed callable with a shorter lockout period can look attractive, but if the CD is called, you will be enjoying that rate for a much shorter period of time. Although the fixed callable with the longer lockout period carries a lower rate, if rates decline, that rate will be above the market rate that you will enjoy for a longer period of time.

Would you like further assistance? Reach out to LaCorp!