Certificates of Deposit (CDs)

Certificates of deposit (CDs) are time bank deposits that cannot be withdrawn on demand. Both interest and principal are paid at the maturity of the CD. CDs can have any term, but Federal Reserve regulations require that it be at least 7 days. Up to $100,000 of a certificate of deposit is insured by the Federal Deposit Insurance Corporation (FDIC). CDs were 1st introduced in the sterling (UK) market in 1958 and in the US market in 1964. The largest investors of CDs are banks, money market funds, corporations, and local government agencies.

CDs can be negotiable or nonnegotiable. Nonnegotiable CDs can't be sold before maturity, so the investor can only receive payment from the issuing bank. If the money is withdrawn before maturity, then the bank pays a lower rate of interest as an early withdrawal penalty.

Negotiable CDs, introduced in the early 1960s, can be sold before maturity in the secondary money market. However, only short-term CDs—less than 3 months—have an appreciable market.

Retail negotiable CDs, with denominations of $100,000 were introduced by Merrill Lynch in 1982. Nowadays, other security firms also offer CDs, and most stand ready to buy back their CDs before their maturity if the investor wants her money early.

Large-denomination negotiable CDs are CDs with denominations of $1,000,000 or greater, and constitute the largest part of the negotiable CD market. Most of the investors of these CDs are investment companies and money market funds, although some banks, municipalities and corporations also buy CDs.

Issuers of CDs

Issuers of CDs are grouped according to the type of bank. The main issuers are domestic banks. Eurodollar CDs (Euro CDs) are denominated on the U.S. dollar but are issued primarily in London by foreign branches of U.S. banks, and by Canadian, Japanese, and European banks. Yankee CDs are also denominated in U.S. dollars and are issued by the United States branches of foreign banks in the United States. Thrift CDs are issued by U.S. depositary banks, such as thrifts, and savings-and-loans banks, which use the deposited money for loans.

CDs can also be grouped as prime CDs or nonprime CDs, depending on the credit rating of the issuer. Prime CDs are issued by highly rated domestic banks; nonprime CDs are issued by smaller, less well-known banks.

CD Yields

Unlike other short-term money market instruments, CDs are not sold at a discount, but pay interest on the money deposited. For CD maturities of less than 1 year, interest is paid at maturity. For term CDs — those with a term of 1 year or longer — interest is paid semiannually. A banker's year of 360 days is used to compute interest for money market instruments issued in the US.

Market yields on CDs are determined by the usual factors that affect rates for fixed-income securities: the credit rating of the issuer, the term of the CD, and market interest rates. Like bonds, the price of negotiable CDs varies inversely with market interest rates: when market interest rates decline, CD prices increase, and vice versa. A major determinant of CD yields is the bank's demand for money for loans and the cost of alternative sources of funding, such as commercial paper. The greater the demand or the higher the cost of alternative funding sources, the greater the yields paid on CDs.

Yankee CDs generally yield more than issues by domestic banks, because investors are not as familiar with foreign banks, and, hence, a lack of information increases the perception of credit risk.

The issuers of Euro CDs have several advantages that allow them to pay a higher interest rate. Because the issuer is not subject to United States laws and regulations, the issuer of a Euro CD does not have to pay insurance to the FDIC for the deposited money, nor is there any reserve requirement for the money. In the United States, the Federal Reserve imposes a reserve requirement on money deposited in U.S. banks. Domestic banks must, therefore, deposit some of the money in its Federal Reserve account, which does not earn any interest, so the bank is not able to use all of the money for its business—hence, it pays a lower rate.

Example—What is the actual cost to a bank with a 5% Federal Reserve requirement of a 1-year $100,000 CD paying 6% interest?

Because the bank must keep 5%, or $5,000, of the money in a Federal Reserve account that pays no interest, the $6,000 interest that the bank is paying is on $95,000, yielding an actual interest rate of 6,000/95,000 ≈ 6.32%. A simpler way to calculate the bank's cost is to multiply the interest rate on the CD by 1 plus the Federal Reserve requirement percentage.

Actual Cost to Bank = CD Interest Rate × (1 + Federal Reserve Requirement Percentage)

In this case, the equation would be:

6% × 1.05 = 6.3%

Adding a typical 8 basis points (0.08%) to the interest rate for FDIC insurance increases the bank's actual cost to 6.4%.

The other factor increasing the yields on Euro CDs is the lack of information regarding the issuer and its government and laws, which creates some uncertainty as to repayment, and in some cases, there is the perception of sovereign risk, which is the risk that if the issuer does not repay the CD, it will be difficult to collect because the issuer is located in another country with different laws and regulations, or the government may not enforce its laws. However, this sovereign risk premium is small for most modern nations.

CD yields are slightly higher than for Treasury securities of the same maturity, because of a higher credit risk and an illiquid secondary market. The yield differential may be higher if there is a crisis in the banking system, such as the recent subprime mortgage crisis, which caused Treasury security yields to decline while yields on other securities went up.

Negotiable CD Yields

Negotiable CDs have terms of less than one year, and since they have a secondary market, their yields will vary with the market interest rate. CDs in the US, like other money market instruments in the US, use the actual/360 day-count convention, so a 1% CD would earn 365/360 × 1% of interest in 365 days. In the United Kingdom, the actual/365 day-count convention is used. Market prices are quoted per $100 of par value. The coupon rate is equal to the stated rate of interest on the CD and is issued at par value. Therefore, the amount received when the CD matures equals:

CD Maturity Proceeds Formula
CD Maturity Proceeds=Face Value×(1 + Coupon RatexTerm of Maturity in Days
Year (Days using relevant Day-Count Convention)
)

Example 1: If a CD issued in the U.S. (Day-Count Convention: Year = 360 days) pays 5% and has a face value of $100 and a term of 90 days, then the amount received at maturity is equal to: $100 × (1 + .05 × 90/360) = $101.26, of which $1.26 is interest.

If the CD sold is sold before maturity, then the market price will depend on the market yield, which is what other interest paying instruments with similar characteristics and credit quality are paying, so the market price will be equal to:

CD Market Price Formula
CD Market Price=Maturity Proceeds
 1 + Market Yield × Days Left to Maturity / Year (Days using relevant Day-Count Convention)

So if the above CD is offered for sale after 30 days, with 60 days remaining to the CD term, and the market yield is now 4%, then the market price would be:

Example 2: CD Market Price
CD Market Price=$101.26
1 + .04 × 60 / 360
=$101.26
1 + .04 × 60 / 360
=$101.26
 1 + 0.007
=$100.56

If the CD is sold before maturity, then the investment return for the holding period on the CD is equal to:

CD Holding Period Yield Formula
CD Holding
Period Yield
=[1 + Purchase Yield × (Purchase Date – Maturity Date) in Days / Year
1 + Sale Yield × (Sale Date – Maturity Date) in Days / Year
– 1]×Year
Days Held

The buyer of the CD in Example 2 sells after holding it for 29 days, with 31 days remaining for the term, when the market yield dropped to 3%. The holding period return is:

Example 3: CD Holding Period Yield
CD Holding Period Yield=[1 + .04 × 60 / 360
1 + .03 × 31 / 360
– 1]×360
29
=[1.0067
1.0026
– 1]×360
29
=5.06%

Calculating Negotiable CD Prices Using Microsoft Excel

Microsoft Office Excel has the PRICEMAT function to calculate prices of negotiable CDs.

PRICEMAT Function

Price of Security that pays interest only at maturity = PRICEMAT(settlement,maturity,issue,rate,yield,basis)

  • Settlement = Date in quotes of settlement.
  • Maturity = Date in quotes when bond matures.
  • Rate = Nominal annual coupon interest rate in decimal form.
  • Yield = Annual yield to maturity in decimal form.
  • Issue = Issue date of the security.
  • Basis = Day count basis.
    • 0 = 30/360 (U.S. basis). This is the default if the basis is omitted.
    • 1 = actual/actual.
    • 2 = actual/360 (this is used for CDs issued in the US)
    • 3 = actual/365 (this is used for CDs issued in the UK)
    • 4 = European 30/360

What is the price of a negotiable, 90-day CD originally issued for $100,000 on 3/1/2008 paying a rate of 8% with a current yield of 6% and a settlement date of 4/1/2008? Here we use the Microsoft Excel Date function, which takes the format DATE(year,month,day) to do some calendar arithmetic. Because the CD is issued in the US, the actual/360 day-count convention is used, which, in Excel, is selected by setting the last parameter to 2.

Market Price of CD = PRICEMAT(DATE(2008,4,1),DATE(2008,3,1)+90,DATE(2008,3,1),0.08,0.06,2)= 100.318 per $100 of face value = $100,318.00

Note: The above calculations were made using Microsoft Office Excel 2007. These functions are also available in earlier versions of Excel.

Taxation of CD Interest

The taxation of CDs is similar to the taxation of original issue discount bonds. Although CD interest is only paid at the end of the term, the CD holder must pay taxes on it every year, as the interest is earned. Most banks charge a penalty if the money is withdrawn before the end of the CD term. This penalty can be deducted as an above-the-line deduction.