What is a Callable Certificate of Deposit?
A callable certificate of deposit (callable CD) is a time deposit with a bank or financial institution. But unlike other CDs, callable CDs can be redeemed by the issuer before the maturity date.
How Does a Callable CD Work? (Example)
For example, let's say XYZ Bank issued a CD that paid a 10% rate with a maturity date in 10 years but was callable in five years at 102% of par.
Five years from the original issue date, XYZ decides to call the CD, which it would likely do if interest rates fell below 10%, as the bank could get cheaper financing by reissuing lower-rate CDs to other investors.
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 five years, but it may only offer 101% if called it in seven years.
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.
Are Callable CDs Worth It?
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.