Callable Certificate of Deposit
What it is:
How it works (Example):
For example, consider a XYZ Bank CD issued in 2000, paying a 10% rate, maturing in 2020, and callable in 2010 at 102% of par. Ten years from issue, XYZ gains the right to call the CD, which it would likely do if the interest rates in 2010 are lower than 10%.
Usually, the issuer must pay the investor a little over par value in order to call the CD. This difference is called the call premium, and the amount typically decreases as the CD nears maturity. For example, XYZ Bank is offering 102% of face value if it calls the CD in 2010, but it may only offer 101% if called in 2015.
The above example covers the basics of the call feature of a CD, but CD rates, terms, and dollar amounts vary from institution to institution. Another common feature allows investors to redeem CDs before maturity, but doing so usually triggers early withdrawal penalties.
Why it Matters:
In general, CDs offer higher returns than savings accounts and traditional money market accounts. This makes them excellent short- to medium-term investments for risk-averse investors, especially those who need a specific amount of money at a specific time.
However, the presence of call provisions adds reinvestment risk. If interest rates rise, the investor is stuck in a relatively low-paying investment until the CD matures. When interest rates fall, the CD issuer is more likely to exercise the call provision in order to retire what has become high-interest debt and reissue the CD at the prevailing lower rate. This leaves the investor with cash that must be reinvested at a lower interest rate.
Thus, because call provisions are less favorable to investors, callable CDs tend to offer higher interest rates than similar non-callable bonds so that the investor receives enough compensation for the risk.