Unique Risks for Callable CDs | Market Risk | Interest Rate Risk | Secondary Market Availability Risk | Call Risk | Re-Investment Risk | Principal Risk
UNIQUE RISKS FOR CALLABLE CDS
Callable CDs present risks unique to this style of CD. Callable CDs pay a fixed interest rate until called. The bank can choose to make the call decision at any call date after the initial non-call period. Investors should be aware of the timing of each call date and the other terms of the CD. If the CD rate is above the current market interest rate and the CD is callable, the underlying CD becomes subject to Call Risk since the bank is motivated to replace the deposit with less costly funds. Reinvestment Risk arises when CDs are called, causing investors to relinquish a high rate and replace it with a lower, current market rate.
All investments, including certificates of deposit (CDs), held in a securities account are subject to market risk. Market risk is present for all securities-the risk that the current market rate for your investment has decline since purchase. Of course, the market price could go up, but that’s a good thing. Most CD investors buy with the intent to hold the CD until maturity. However, there is the potential risk is that the value may fall and transaction cost may be incurred if the item is put up for sale. This risk could become a real loss if holdings are actually sold.
Market values are estimated on FISN Division brokerage accounts’ monthly statements produced by National Financial LLC, which provides Clearing, Custody and Safekeeping services for Landolt Securities. Many fixed income securities, especially CDs, do not trade frequently so that these prices reflect and estimated current market price rather than an actual price of a security sale. If you wish to get a current market bid for your CD or other fixed income security, please speak to your FISN representative. It is possible that the value could rise, and then it would be a market value gain. Market risk is an overall risk caused many factors such as interest rate movements, transaction costs and availability of purchasers for your security.
INTEREST RATE RISK
All investments that pay interest or dividends are subject to interest rate risk. Certificates of deposit (CDs) are included since their primary purpose is to produce income in the form of interest payments. Interest rate risk is present if interest rates are moving up from the original rate that you purchased. The amount of interest income you receive relative to the income possible from a current higher rate is the risk you take when committing yourself to a purchase. It is not realistic to assume rates will always remain at the levels prevailing when you made the purchase-rates go up and they go down over time. The way to remember which way market value moves is simple: if rates rise, the “market” value will fall. Your will likely receive less money than you paid for your investment. When rates fall, the “market value” will rise. You will likely receive more than you paid for your investment.
Purchasers in the secondary market demand the yield on previously issued CDs be increased to current levels before they buy them. Since the interest rate on the CD cannot be changed, these yields are increased by reducing the prices. This risk could become a real loss if holdings are actually sold.
SECONDARY MARKET AVAILABILITY RISK
The sale of all investments is subject to the availability of a secondary market. The availability of secondary markets affects Income producing investments, including certificates of deposit (CDs), because they do not trade like stocks do on an organized and well established “market”. The risk is the lack of such an organized marketplace. Fixed Income (including CDs, Municipal and Corporate bonds) trades in an over-the-counter marketplace which consists of sales between brokerage firms via telephone and computer. However, most investors purchase CDs with the intention of holding them to maturity. In that case, the possible lack of a buyer will not affect the investor.
The FISN Division of Landolt Securities, Inc., though not obligated to do so, may maintain a secondary market in CDs after any initial distribution. Simply stated - buyers are needed in order for the investor to sell any investment. While the FISN Division, the original distributor of the issue or any other brokerage firms active in the over-the-counter market endeavor to make a market in CDs, there is no guarantee that a buyer will be found for an investment. The risk of selling an investment is that the price a buyer is willing to pay can be greater or less than the original price paid for the investment. This risk could become a real loss if holdings are actually sold.
Callable investments, including callable CDs, are subject to call risk. Depositors should clearly understand all the call provisions of their investment. This call risk is present even if you plan to hold CD investments until maturity. The bank can “call” or redeem a CD on certain call dates prior to maturity. The bank calls the entire issue regardless of the holder. When called, the bank returns the full deposited amount with interest up to the call date. Only the bank can exercise a call, not the account holder or the broker. Banks usually call a CD when rates have fallen and they can replace the deposit at a lower rate. The risk is that, even though you get back your full deposit, when you go to reinvest these funds, it will earn a current, lower rate. Never rely on a call to receive funds back from an investment early. It is possible that even if rates have fallen that the bank will not call a CD. Calls cannot be predicted since banks consider only their own funding needs and costs.
All fixed income investments are subject to re-investment risk. This risk is related to what you do with the funds when an investment ends, regardless of the reason. If you plan to continue investing, you have to re-enter the marketplace to find a new replacement investment. One side of this “risk” is that rates may be lower and/or fewer products are available. It is possible that rates may be higher and/or more products are available. Strategies to lessen this risk: time investment maturities close to when you might need the money, go long when rates appear high and to go short term when rates appear low. Some investors do both by laddering the maturities of their investments between long and short terms. Longer term CDs capture higher returns from longer investments. Shorter maturities keep the remainder of your funds regularly available so rate swings are not missed.
All investments are subject to principal risk. This risk is connected to the issuer. If the financial outlook of issuer declines, the issuer’s credit rating could be downgraded or the issuer could actually default on its debt. With most debt, if the issuer is less credit worthy, the debt will fall in value. And, if the issuer cannot repay the debt at all, the investment may be near worthless. The principal value will diminish in either case.
With FDIC insured CD investments the risk of insolvency, the banking version of corporate default, is lessened. When properly held and registered, FDIC insurance covers principal and interest up to $ 250,000.00. The FDIC usually transfers deposits to a viable bank or simply returns the deposit when a bank fails. While the return of funds by the FDIC is usually prompt, in certain cases in can be a lengthy process.