Are CDs Good Protection for a Bear Market?

A bear market is usually an indication of a sluggish economy and a decrease in the value of overall securities. Consumers tend to be pessimistic in their outlook about financial assets and the economy as a whole during these times. Investors tend to look into where their investments can be better protected in a bear market or which investment vehicles to add to their portfolios to help lessen the blow to their stocks and equity investments.

Products that investors commonly look into during these difficult times are more stable, income-producing debt instruments such as certificates of deposit (CDs).

What Is a CD?

A CD is a short- to medium-term deposit in a financial institution at a specific fixed interest rate. You’re guaranteed the return of your principal plus a fixed amount of interest at maturity at the end of the term. The period of the term varies but you can generally purchase three-month, six-month, nine-month, or one- to five-year CDs. Some banks offer even longer terms.

Penalties for Early Withdrawals

CDs are considered time deposits because the purchaser agrees at the time of purchase to leave their deposit in the bank for a specified period. Make sure you can afford to let go of some of your money for a certain period before committing to a CD because you’ll be liable for a penalty if you decide to take the deposit back before maturity.

The penalty can vary from a minimum of a week’s worth of interest to several months’ interest. Fees and penalty amounts are required to be disclosed upon opening the CD account. There’s typically no maximum penalty for early withdrawals.

A major drawback to withdrawing before the term is due is that the penalty could decrease not only the interest you’ve earned but the principal amount as well. This can happen if you purchase a 13-month CD and decide to cash it in at three months. The penalty would be to pay off six months’ worth of interest but your CD hasn’t even earned that amount of interest yet so the penalty digs into your principal amount.

Guaranteed Returns

CDs are considered to be low-return investments but the return is guaranteed at the specific interest rate even if market rates go lower.

Typical CDs aren’t protected against inflation, however, so try to buy one higher than the inflation rate so you can get the most value for your money. The longer the term of the CD, the higher the interest rate will be. Rates on CDs aren’t the highest in the debt instrument market but CDs earn more in interest than most money market accounts and savings accounts.

CDs vs. Stocks

Stocks tend to have a higher rate of return than most securities but this is because of the higher risk involved. The stockholders will be the first to feel it when a company goes through rough times. The value of your portfolio may be compromised if the stock loses value as a result of bad management or a lack of public interest in its products or services.

The stock market went through turbulent shifts during the Great Recession and its aftermath, resulting in great losses for some stockholders. CDs are one option that can help protect your investment from times of turmoil by providing stable income. The returns gained from these investments usually won’t be as high as those provided by stocks but they can serve as a cushion to balance your portfolio and keep it afloat when the market is down in the dumps.

CD rates are locked in for a certain period so the agreed-upon interest rate at the time of purchase is the interest rate that will be gained on the CD despite how poorly the market might be doing. CDs are also almost always insured unlike stocks and various other investment vehicles.

Guaranteed Protection

CDs are guaranteed by the bank to return the principal and interest earned at maturity. The Federal Deposit Insurance Corp. (FDIC) insures CDs for up to $250,000 for each depositor at each insured bank. It will guarantee payment of your CD investment if the bank goes under. The National Credit Union Administration (NCUA) serves the same purpose for its insured credit unions.

Knowing how much insurance you have against bank failure is essential when the stock market isn’t faring well. Investors tend to look deeper into insured investments during these times. Neither the FDIC nor the NCUA insures stocks, bonds, mutual funds, life insurance, annuities, or municipal securities.

Look into how well the bank is doing when you’re searching for CD products. The FDIC maintains a watch list of banks that might be in trouble but it never releases ratings on the safety of financial institutions to the public. Consumers must visit the listings of several financial institution rating services that are provided on the FDIC’s website.

You can also buy CDs through brokerage firms or online accounts but a drawback to buying through a brokerage account is that the broker is considered a third party to the transaction. It’s buying the CD from a bank and selling it to you. It will take longer to get your money back if the bank fails because the request will have to go through the brokerage rather than directly to the bank.

CD Laddering

CD laddering can provide a flexible security blanket when it’s done properly. Laddering helps lower your risk while increasing your return because it allows you to continue investing in the highest-rated CDs available. The method is to use your funds to buy CDs at different maturities and interest rates. Research the best rates when you start a CD ladder, either locally or in different states.

Let’s say you have $5,000 in your minimal interest-bearing savings account. You want to make the most of your stationary money so you decide that a CD with an interest rate of 3% looks much more appealing. Don’t invest money you might need for emergencies. Start your ladder after you decide that this is money you can afford to lock up for some time.

You can begin by buying five CDs at various rates and maturity dates. The ladder could consist of purchasing the following CDs at $1,000 each:

You’ll have the flexibility of either reinvesting by rolling it into a higher CD rate or cashing it out when the first CD matures. Laddering involves rolling it over. Consider rolling it over into a higher-rated five-year CD when your one-year CD matures.

When your second-year CD matures, roll it over into another five-year high-rated CD when your two-year CD matures and continue doing the same until you’ve rolled over all your initial CDs. A CD in your ladder will mature each year so you’ll always have liquid money available.

The advantage of laddering like this is that you’ll always get the benefit of the highest interest by rolling into the longer-term five-year CD.

Tax Consequences

The interest that you earn on your CD throughout its term is taxable. The amount of tax due will depend on your tax bracket. You must report the total interest that you earn on the CD every year, according to the Internal Revenue Service (IRS). You’ll be taxed on the amount earned in that year even if the interest on the CD wasn’t paid to you directly.

Interest income is considered ordinary income and it’s taxed as such along with your earnings from work or employment.

The Bottom Line

CDs are a comparatively safe investment. They can provide a stable income regardless of stock market conditions when they’re managed properly.

Always consider emergency money that you might need in the future when you’re thinking of purchasing a CD or starting a CD ladder. Laddering can help protect your investments by providing you with stable interest income in a bear market but make sure you can afford to do without that money for the term of the CD and investigate the institution that you decide to buy from.