What is a Callable CD? and Why Current Callable CDs Don’t Make Sense

I generally don’t like Certificates of Deposits because the math doesn’t make sense, but I received an e-mail today about Callable CDs that made me really mad.  I had heard of Callable bonds, but don’t have any recollection of a Callable Certificate of Deposit, so I figured I would share what I learned about them and the e-mail that angered me. 

What is a Callable CD?

Investopedia provides a very easy definition for a Callable CD,

Just like a regular CD, a callable CD is a certificate of deposit that pays a fixed interest rate over its lifetime. The feature that differentiates a callable CD from a traditional CD is that the issuer owns a call option on the CD and can redeem, or “call”, your CD from you for the full amount before it matures. 

So like a regular CD the bank is going to take your money and lock it up; for this they allegedly provide a higher interest rate.  But in a Callable CD the bank can “call” the CD and give you back your money early, or the bank could choose to let the CD stay till the maturity date.  So essentially, the Bank is shifting the risk that interest rates will change to you, the consumer. 

Watch out for Callable CD Advertisements?

I received this email today in my capacity as a Registered Represented,

Dear Representative,

For your clients that expect interest rates to rise over the next few years, please consider the following Step Up CD investments.  These instruments are designed to step-up in coupon at pre-determined dates and percentage increments.  The Advisor offering these to their client must be Series 7 Licensed. 

***

Offering

ABC Bank Step Coupon CD Maturing 10/16/2017

Callable 4/14/11 @ 100

The Coupon starts at 1.5% through 4/13/2011 and then steps up at the following rates

2.000% to 4/13/12

2.500% to 4/13/13

3.000% to 4/13/14

4.000% to 4/13/15

5.000% to 4/13/16

6.000% to 4/13/17

7.000% to 10/16/17

This CD distributes income monthly and may be called @ PAR annually. 

Offer the CD @ PAR = 1.5% YTW 3.54% YTM.  Compare to the two year treasury at 1.06% and the 7 year treasury at 3.33%

Woah, so let me get this straight:

1. ABC Bank you are going let give you money to ‘lock up’ for 1.5% for the next year (ING is paying 1.1% so you are LOCKING UP MONEY FOR .4%?)
2. At that point if current interest rates are above 2% you won’t call my CD? And you’ll keep the cheap money…BUT
3. If the prevailing interest rates are below 2% you’ll call the CD give me my money back and sell a CD to another Sucker.

The bank is essentially shifting interest rate risk to you, for next to no money and with NO guarantee that you’ll ever see those larger interest rates.  Does anyone believe that interest rates are going down? If not, then why would anyone use this product? 

Readers: Am I missing something? Has anyone used a Callable CD in their Investment/Cash Portfolio?