I was recently flipping through the channels and I happened to notice an advertisement for Ally Bank's "Raise Your Rate CD". Now by no means am I a novice to the Certificate of Deposit game, but this particular commercial happened to catch my eye. What was particularly perceptible was the fact that this type of product would appeal quite completely to the average person. It's no secret that rates are near all-time lows and volatility scares are bountiful. Banks know these things and the people at banks are likely to be both intelligent and widely capable of taking advantage of the opportunities at hand. In fact, when placed in isolation, this "raise your rate" concept is likely to be appealing to almost anyone. You guarantee your principal, earn a competitive CD rate, and if your worst fear comes true, rates rise, you stand to benefit.
However, we all know that banks are in the business of making money and not necessarily for the purpose of helping their fellow depositor. Thus it must follow that while the "raise your rate CD" is a benefit to the depositor, it provides an even greater benefit to the bank. And we see this in two fashions: first, the bank is able to lock in your money at a very low rate. If their rates happen to go up in the future, they are simply agreeing to pay you what they would normally be paying to any other customer. Second, the math might work against you anyway. Let's run through a numerical example to better illustrate this point.
The current rate on the 2-year "raise your rate CD" at Ally Bank is 1.14%, which places it 3rd amongst national high-yield CDs according to bankrate.com. First on the list is CiTBank with a 1.24% 2-year rate. Now let's imagine that after the first year, the 1-year rate at Ally Bank raises to 1.3%, a 30% increase from their current 1% offering. Aren't you glad you went with the "raise your rate CD"? Not yet. In the first year, on say $1,000, you would make $11.40 with the Ally Bank 2-year "raise your rate CD". (Yearly compounding to simplify) In the second year, you would make $13.15, for a total of $24.55. However, if you happened to go with CiTBank's 1.24% 2-year rate, you would have made $24.95. In fact, one would need a 1-year rate in one year of about 1.34% at Ally Bank in order to justify going with the "raise your rate CD". So the real question is not: "do you think interest rates will rise?" but more aptly "do you think Ally's 1-year CD rate will rise to more than 1.34%?"
Two things should be noted here. First and foremost, the "raise your rate CD" option does in fact bring value. If you simply went with Ally's 1-year CD rate of 1%, one would need a 1.48% 1-year rate in a year in order to compete with a current 1.24% 2-year rate. Second, whether the ending 2-year amount is $24.55, $24.95 or even $25, based on a $1,000 principal, those numbers should appear abysmal by any calculation.
I would liken this point to an example in a mutual fund prospectus that I recently read. Towards the back of the prospectus it had an illustration of the varying fees. Within this example, there was text that went something like this: 'This illustration is provided to allow for a comparison of the fees in this mutual fund to the fees in other, comparable mutual funds.' Assuredly this is important, as one must always compare an investment to its competitors. However, one should not just limit themselves to their competitors, but more appropriately to every available alternative. More specifically, while mutual fund fees should indeed be compared to other mutual fund fees, they should also be compared to the fees of ETFs and holding individual stocks.
Much in the same manner, the "raise your rate CD" should not just be compared to other CDs but more suitably to the available alternatives. It is not a question that a CD with a higher initial rate and an option to increase this rate in the future would trounce a CD that does not offer this option. In reality, both options are likely losing purchasing power over time through inflation given the current low rate environment. A better alternative within the "raise your rate" universe would likely be dividend growth stocks.
Surely there are other alternatives out there; perhaps you can suggest a few, but the dividend growth stock is one substitute that I have no qualms about comparing to a CD. In fact, just a couple of months ago I declared that dividend growth stocks were the '10-year CD of Today'. Within the article, I picked out 5 dividend growth stocks: Coca-Cola (NYSE:KO), PepsiCo (NYSE:PEP), McDonald's (NYSE:MCD), Johnson & Johnson (NYSE:JNJ) and Procter & Gamble (NYSE:PG) as a proxy for a wide array of a portfolio of dividend growth stocks. The idea was to hold a large collection of these types of companies and to ignore the underlying price fluctuations for the next 10, or even 20-30 years. Instead you focus on the dividend income that they provide much in the same manner that you would collect interest income from a CD.
So why exactly is a portfolio of dividend growth stocks a better option than the current low-interest CDs? Glad you asked.
If you happened to hold equal proportions in the 5 aforementioned dividend growth stocks, you would have a current yield of about 3.16%. Compare this to a 1.14% 2-year rate and there really is no comparison. You could earn that same $25 that took you 2-years time with the CD (and that was with rates increasing) in just over 3 quarters with the individual stocks. Obviously, if low-interest accounts eventually raise their rates significantly, this comparison becomes both much closer and more paramount.
Maintaining Purchasing Power
If you assume inflation to be around 3% over the long-term, any agreement to lock in a lower rate on your money is not just guaranteeing principal but more fittingly is guaranteeing a loss in purchasing power over time. For example, let's say you can buy a new scooter for $1,000 today with that price increasing by inflation for the foreseeable future. You currently hold $1,100, but decide to delay that purchase by keeping those 11 $100 bills in a CD yielding 1%. In just 5 years time, you would be unable to make that new scooter purchase that you could have had $100 left over with a purchase today. Thus you are worse off. On the other hand, dividend growth stocks provide payouts that are comparable or better than inflation and tend to increase by a rate that far outpaces inflation. Additionally, given that we don't see 30% dividend yields on Coca-Cola or McDonald's, the corresponding capital appreciation allows for an increase in purchasing power as well.
Raise Your Rate… Every Year
While the option to raise your rate once is certainly a benefit for the CD holder, it pales in comparison to the holder of a collection of dividend growth stocks. They enjoy this benefit every single year: Coca-Cola and Johnson & Johnson have raised their dividend for the last 50 years, McDonald's for the last 35 years, Procter & Gamble for the last 56 years and PepsiCo for the last 40 years. This means that if you happened to own a portion of these companies in the last few decades, you most certainly received a larger dividend check each and every single year. Moreover, these increases haven't just kept up with inflation, but more pertinently have doubled or tripled inflation on a yearly basis.
Refocus Your Risk
The obvious knock on holding a collection of dividend growth stocks versus a CD is that one's principal is in no way guaranteed. And in the short-term this is likely a very formidable concern. In fact, in no way I am advocating that one should hold a collection of dividend growth stocks, no matter how wonderful they are, in the place of low interest equivalents in the short-term. However over the long-term, given the current alternatives, a collection of dividend growth stocks is the perfect alternative to a low-interest CD. The lack of a guarantee with regard to principal should be of no concern to the very long term investor; say 10 years to forever. Indeed, short-term negative price fluctuations ought to be cheered rather than feared, as they offer buying opportunities.
In 20 or 30 years, if you happen to want to sell some shares of one of your holdings, consider what must occur to a Procter & Gamble or PepsiCo for their share price to be lower than what you paid. If PG and PEP currently yield around 3% and increase their dividend by say 6% on average for the next 30 years, this results in a yield on cost around 17%. In order for the shares to be selling for less than they are today, the market would have to be offering a 17% dividend yield on PG or PEP. It's ludicrous. The more likely scenario is that PG and PEP will be offering a yield in the 2-5% range and you will have enjoyed a steady price appreciation; not to mention the timely inflation beating dividend payments along the way. The true risk comes not in principal fluctuation, but rather in the form of one of your holdings freezing or cutting their storied record of dividend increases. While this is in fact a proper concern, it loses its luster once one has accumulated an adequate assortment of dividend growing machines.
Disclosure: I am long KO, PEP, PG, JNJ, MCD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.