CD stocks, more accurately called brokered Certificates of Deposit (CDs), function as debt instruments you can trade on the secondary market, unlike traditional bank CDs. Here’s a breakdown of how they work:
Understanding Brokered CDs vs. Bank CDs
It's important to distinguish between two types of CDs:
- Bank CDs: These are purchased directly from a bank or credit union. They are typically held until maturity, and early withdrawal usually incurs a penalty. They are not traded.
- Brokered CDs: These are sold through brokerage firms. A key difference is their tradability. They can be bought and sold on the secondary market before their maturity date, similar to bonds.
How Brokered CDs Work
- Issuance: A bank issues a large-denomination CD and sells it to a brokerage firm.
- Distribution: The brokerage firm then divides the CD into smaller units and offers them to individual investors.
- Trading: Investors can buy and sell these CD units through their brokerage accounts before the CD's maturity date. The price is determined by market conditions and interest rates.
- Interest Payments: Investors receive periodic interest payments (usually monthly, quarterly, or semi-annually) based on the CD's fixed interest rate.
- Maturity: At maturity, the investor receives the CD's face value.
Key Features of Brokered CDs
- Fixed Interest Rate: Brokered CDs offer a fixed interest rate for a specific term.
- Tradability: Unlike bank CDs, brokered CDs can be bought and sold on the secondary market.
- Liquidity: The ability to sell brokered CDs before maturity provides liquidity, although the sale price may be higher or lower than the face value.
- FDIC Insurance: Brokered CDs are typically FDIC-insured up to \$250,000 per depositor, per insured bank.
- Call Features: Some brokered CDs are "callable," meaning the issuer can redeem the CD before its maturity date.
- Variety of Terms: Brokered CDs are available with a range of maturities, allowing investors to match their investment horizon.
Buying and Selling Brokered CDs
To buy or sell a brokered CD, you'll need a brokerage account. The brokerage will act as an intermediary, facilitating the transaction on the secondary market. Keep in mind:
- Market Price: The price of a brokered CD fluctuates based on factors like prevailing interest rates, the CD's credit rating, and its time to maturity. If interest rates have risen since the CD was issued, the CD may trade at a discount. Conversely, if rates have fallen, it may trade at a premium.
- Commissions and Fees: Brokerages may charge commissions or fees for buying and selling brokered CDs.
- Due Diligence: Before investing, review the CD's prospectus, which provides detailed information about the issuer, terms, and risks.
Example
Imagine a bank issues a \$1 million CD to a brokerage. The brokerage divides it into 1,000 units of \$1,000 each and offers them to investors. An investor buys 10 units. If the investor needs cash before the CD matures, they can sell those 10 units on the secondary market through their brokerage. The price they receive will depend on current market conditions.
Important Considerations
- Interest Rate Risk: Rising interest rates can decrease the market value of your brokered CD if you need to sell it before maturity.
- Call Risk: Callable CDs can be redeemed by the issuer before maturity, potentially forcing you to reinvest at a lower rate.
- Credit Risk: While FDIC insurance provides protection, understanding the creditworthiness of the issuing bank is important.
Brokered CDs provide a way to invest in fixed-income securities with the added flexibility of trading on the secondary market, but investors need to understand the associated risks and features before investing.
