Welcome to this month’s Ask the CFP® segment. This month’s question is, “Why do CDs and bonds lose value when interest rates increase?
When you think of a certificate of deposit, or CD, at your local bank, you normally think of security and stability. With a CD, you generally have a guaranteed interest rate for a period of time, backed by the FDIC to certain limits. CDs are thought of as low-risk investments for this reason. While they are low risk, they can still lose value and many people have experienced this as the Federal Reserve Bank has increased interest rates in 2022 and 2023. In fact, some CDs can lose more value than they pay in guaranteed interest. So why does this happen?
If you buy a direct CD with a bank, you likely won’t see the value change except for increases when you receive interest. However, when you buy a CD on the open market – one that can be bought and sold even before maturity – the market value is typically adjusted on a daily basis. While both direct and market-traded CDs may be the same financial instrument, market-traded CDs can fluctuate in value from day-to-day because of the daily market value, but CDs held directly with banks do not.
CDs and bonds experience the same type of impact with interest rate changes. Let’s say you purchased a CD or a bond in 2021 at 1%. The Fed Funds Rate, which influences interest rates in the economy and is set by the Federal Reserve Bank, was near zero at the time. Let’s also assume this CD or bond matured in 5 years. By the second quarter of 2023, the Fed Funds Rate increased to around 5%, pushing market rates for many CDs and bonds with it. Therefore, if you wanted to sell your investment in the open market to another person, do you think they would pay you top dollar for a 2021 bond paying 1% when they could find a brand new one paying 5%? Instead, you would have to discount the price to entice someone to buy your 1% bond. This is the reason CDs and bonds often appear to lose value when interest rates increase.
Keep in mind, the “loss” you may see on a CD or bond may be temporary. With the 2021 bond at 1%, it may appear as though it’s currently at a loss, but as long as the issuer doesn’t go out of business, you’re still likely to receive the par value of the bond at the date of maturity. This means a $50,000 bond may show that it’s only worth $45,000 today, but if held until maturity two years later, you would receive $50,000. Plus, you would receive interest, too. Therefore, if these investments are held to maturity, their decline in value may be temporary.
If you have a question about this topic or have a question for a future video, please send it to kluetters@monetagroup.com. Thanks for watching and we’ll see you next month.
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