With different banking regulations and no FDIC protection, foreign banks bring additional risk that might outweigh the relative safety of CDs.
Question: My wife and I are both unable to work and live on a fixed income. We supplement our income with interest from a 5.5% CD which matures this month. If we let the CD renew, the interest rate will be around 3.5%. I found a 6% CD at a bank in St. Vincent and the Grenadines, but I am somewhat leery of a foreign bank. What are your thoughts? –Alan Brady, Greensboro, North Carolina
Answer: My first thought is of the movie version of “A Man for All Seasons,” which depicts the life of St. Thomas More, the scholar and author of “Utopia” who was beheaded for treason in 1535 for refusing to recognize Henry VIII as the supreme head of the Church of England. I’m thinking specifically of a scene at More’s trial in which More, played by the late actor Paul Scofield, confronts Richard Rich, who has perjured himself and betrayed More to secure the position of Attorney General of Wales. “Why Richard,” says More, “It profiteth not a man to gain the whole world and lose his soul. But for Wales?”
What does this have to do with buying a CD from a bank in the Caribbean island nation of St. Vincent and the Grenadines?
Well, it seems to me that you and your wife could be jeopardizing your financial security by taking extra risk with money that you clearly depend on. And for what? A couple of percentage points of annual return?
I suppose it could all work out fine. But do you really want to subject this money to foreign banking rules and regulations? Do you even know what those regulations are? (I noticed that one bank in St. Vincent and the Grenadines that advertises U.S. dollar-denominated deposits won’t allow early withdrawals from some of its CDs.)
And by moving your money outside the U.S. you’ll also be foregoing the protection of FDIC insurance, which means you’re relying solely on the solvency of the bank.
Of course, the desire for a higher yield often leads us to overlook potential risks. But that doesn’t mean the risks aren’t there.
If it sounds too good to be true…
Indeed, today we’re seeing thousands of people who are paying dearly after stretching for extra return in what they thought were “can’t lose” deals.
Take the case of bank-loan mutual funds, which invest in variable-rate corporate loans and were touted as ways to earn higher returns than money-market funds without much extra risk. Investors who bought into that argument 12 months ago are now nursing losses of 7% or so.
And how about investors who snapped up auction-rate preferred shares, investments that were marketed by closed-end funds and other issuers as a way to get safe high returns on your cash? Problem is, the auctions for these securities has dried up, leaving most investors unable to sell their shares for cash and investment firms scrambling to provide liquidity for disgruntled investors.
Even supposedly sophisticated investors like hedge funds and investment banks are still reeling from billions of dollars of losses they sustained after reaching for extra yield in what they believed were highly-secure packages of subprime mortgages.
Risk and return
I know that falling interest rates can make it difficult to get by for people like you and your wife who are depending on income from CDs or other fixed-income investments. But it’s important to understand that just because you need more investment income or a higher return doesn’t mean you can get it, at least not without taking on more risk.
So what do I suggest you do instead of moving your money abroad?
Well, normally I would recommend against relying on any one asset class, including CDs. Instead, I think it’s generally a better idea to create a diversified portfolio that would include CDs, high-quality bonds and even some stocks that can generate both current income and the potential for growth in order to maintain purchasing power in the face of inflation.
But I understand that many people simply aren’t interested in pursuing this sort of strategy for any number of reasons and may prefer to stick with something they understand and feel more comfortable with, like CDs. So assuming you fall into that group, I think your best bet is to find the highest-yielding CDs you can that are also backed by FDIC insurance. This way, you may be able to get a slightly higher yield than you can find at your local bank without subjecting your money to any significant additional risk.
I notice that you also talk about having “a” CD – that is, just one. When it comes time to renew your CD, you and your wife may also want to think about creating a “CD” ladder – that is, spreading your money among several CDs with progressively longer maturities, say, from six months to five years.
By doing this, you’ll have some CD money coming due on a regular basis. Thus, if interest rates begin creeping up again, you’ll be able to reinvest funds from maturing CDs at prevailing higher rates.
I realize that this may not be as appealing a solution as getting a fat yield on a foreign bank’s CD. But if nothing else, the mess that many investors are dealing with now shows that sometimes it’s smarter to accept a lower but secure return than shoot for a higher and riskier return that may turn out to be illusory.