In Search Of Higher Returns: A Saver Experiments With Callable CDs And Bonds

With CD rates continuing to drop, I’m considering different strategies for redeploying maturing deposits.

One is buying long-term callable CDs and federal agency obligations.

These instruments are subject to early redemption, at face value, at the issuer’s (but, sadly, not the holder’s) option.

So you can earn a higher interest rate when compared with, for example, government-insured certificates of deposit with the same term.

But interest-rate risk is shifted entirely to the investor.

If rates go up, you’re stuck with the lower rate; if they go down, you’re out because the bond or CD will be called before maturity.

Last year, I experimented with a 4 1/2-year Federal Home Loan Banks system step rate callable bond. (The FHLB system is a government-sponsored enterprise, not a group of true banks. Its consolidated debt is not FDIC-insured.)

It had an initial 1% rate, increasing in stages to 6% immediately prior to maturity.

Although the blended yield was a pretty decent 2.95% on a 54-month term, the yield to call (the interest rate I would receive if the bond was called early) was just a so-so 1%.

I got the yield to call, naturally.

The FHLB redeemed the bond after three months (on the first available call date), a week following the Fed’s announcement that interest rates were expected to remain “exceptionally low” until mid-2013. (Obviously, the interest rate prediction has changed since then.)

Although soured on callable obligations of the step-rate variety, I remain interested in the fixed-rate variety.

The trick seems to be identifying an adequate yield premium and a sufficient no-call period to compensate for the interest rate risk.

I have no formula or model — just gut feeling.

I’ve recently looked at some 10-plus-year obligations, using the 2.50% APY 10-year Discover Bank CD as a rate benchmark. (Discover’s 10-year CD rates fell to 2.45% APY this week.)

Fidelity was showing an FHLB 10-year bond with a fixed 2.65% coupon and a one-year no-call period.

It was interesting but not compelling.

FHLB bonds are only implicitly guaranteed by the government. Discover’s CDs are fully FDIC-insured.

Fidelity also showed a Toyota Financial Savings Bank 10-year, 2.55% CD, fully government-backed, but only providing three months of call protection.

Also, like all brokered CDs (which most callable CDs are), a holder can’t redeem early (except upon death) but must sell in the market, which could mean you might not get back what you paid for the CD.

In contrast, a 10-year Discover CD can be closed with a nine-month interest penalty but no loss of principal.

A Goldman Sachs Bank USA 15-year, 3.2% CD offered through Vanguard seemed intriguing.

The rate was attractive, but the paltry six-month call protection wasn’t.

I’d need at least a year (no — two years!) of call protection in a CD maturing when I’m 80.

Anyway, I’ll keep looking for something acceptable.

It’s got to be out there — somewhere.