An advisor has requested my opinion on a Step-Up Callable CD, which I was keen to consider as it relates well to two of our recent discussions on tapering and callable notes. There is no link to the CD we are analyzing as they are not filed in a similar fashion to structured notes.
Why are we interested?
Structured CDs have become very popular over the last few years. While there is no effective way to tally the annual notional issuance of Structured CDs, I have heard estimates of $25 - $40 billion- a large segment of the market worth exploring. Driving this growth are two dynamics: 1) investors pulling back from risk and 2) the low interest rate environment. Theoretically in a Structured CD, the CD component addresses risk concerns while the structuring enables an increase in yields. However, as I have discussed previously, a callable feature can often be a costly element for an investor -- and structures that make use of them often aren't as attractive as they appear at first.(Spoiler alert: No, I do not think so. The extra initial yield does not feel like enough to cover the fact that as of the callable date on this note the investor can never really win. I will analyze why and point to potentially better instruments in the market.)In today's Deconstructed Notes, I will revisit the question of whether the extra initial yield paid by the issuer in exchange for the call provision is worth it.
The CD I am deconstructing and analyzing today has a potential 15-year term. This CD has a call feature enabling the issuing bank to call the CD pretty much any time after 5 years.
The terms of the CD are as follows:
- Periodic Interest: Interest rates will be paid quarterly at the rate illustrated in the below table:
- Call Provision: The bank can call the CD beginning on October 23, 2018 and on every interest payment date thereafter at par plus accrued interest. The callable period is highlighted in light gray above
It is important to remember that the call provision allows the bank to call it at any time. I would like to stress that the bank will call this note if it has access to markets at better rates. So, if the bank does not call the CD it means that rates have moved higher and the bank does not have the capability to borrow at or below the CD rate they are paying. If they do call the CD, rates have moved lower and there will most likely not be the opportunity for you to acquire an equivalent yield in an equivalent product (e.g. CD, government security). In summary, as of the callable date, the investor can never really win. So how much extra is the bank paying currently for the call provision?
Reviewing CD rates on Bankrate and Fidelity, a 5 year (non-callable) 2% CD is attainable. So in our Structured CD, the bank is paying the investor an additional 1% coupon annually. But I believe this CD poses some serious risk due the call provision. Is the extra 1% annual yield worth it? The way I view it is as follows:
- If rates increase, then the duration of the CD increases because the bank will not call the CD. 10 year (non-callable) CDs are already offering a better yield (roughly 3.25%) than this Structured CD, which means you will easily underperform a non-structured CD for the 10-year period.
- If rates remain the same or decline, the bank will most likely call the CD. If the duration in reality is 5 years, this is one way to win vs. a traditional 5 year CD.
- However, as we noted in the point above, the risk of being wrong is that the investor's money will be tied up for the next five to ten years earning less than current rates.
- In addition, if the investor feels strongly about a decline in interest rates, there are other and potentially better ways to play that (e.g., TLT). If the investor feels strongly about wealth preservation, a 10-year CD seems more compelling.
There are a few additional details a potential purchaser of this sort of CD should be aware of:
Brokered CDs (as opposed to Bank CDs) do have a secondary market. However, based on my quick review of Fidelity's marketplace, I believe this market to be rather wide. Of the hundreds of CDs offered in the secondary market, only one of them had a bid. Based on what I have seen, the all in cost to value is probably somewhere between 25 and 50 basis points. With 5 years left on a note that will translate to roughly a 1.125% to 2.25% discount on premium ($1.125 to $2.25 on a $100 value).
In terms of a fair value assessment, a 1% rate increase results in over a 5% loss to principle value for a five year duration. You can do this analysis yourself in Excel using the PRICE function (use the help function if unfamiliar with the formula, it is relatively straightforward). For example, I inputted a 6 year term and placed rates at 3.7%, the blended rate for years 2018 to 2024. If rates increase whereby the fair value rate is 0.25% above the blended rate (3.7%), the bond will be valued at 98.68% (and a 1% difference ~ 95%). I would then assume an additional 1.5% discount due to the inefficient secondary market, resulting in roughly a 3% loss on a .25% yield differential!
As you know, there is talk of the Fed tapering which would result in an increase in yields in the short term, and conventional thinking is that rates will continue to rise in the long term. Be very careful with dealing with callable CDs, especially when longer duration. It is hard for me to envision a winning situation for the investor vs. purchasing a traditional CD or a more suitable instrument for making a directional trade on interest rates - e.g., TLT.