Certificates of Deposit: what are they? A complete guide

As the ECB raises interest rates, certificates of deposit are regaining popularity among those who wish to invest a sum of money and keep the funds tied up for a fixed period.

Rising interest rates are good news for investors seeking stability, as certificates of deposit offer a guaranteed, fixed interest rate. These securities become particularly interesting for those who want to protect capital and obtain more advantageous returns compared to other financial options.

Although certificates of deposit have been less popular in a low-interest rate environment, the current situation makes them attractive again, providing superior returns without compromising the safety of your invested capital.

This comprehensive guide to certificates of deposit will provide further details on the key aspects to consider, such as choosing the best term to maximize returns, the associated risks, and possible investment strategies.

What are certificates of deposit

Certificates of deposit are banking products that allow investors to deposit a sum of money with a credit institution for a specified period.
In essence, certificates of deposit are restricted securities which are issued by banks against a restricted deposit of a sum which gives the customer the right to obtain a refund (principal + interest) at the end of the expiry of the bond.

They have a variable duration, depending on the issuing bank, which varies from 2 to 5 years and can have a fixed or variable return.
Furthermore, the interest accrued and recognized by the customer subscribing to the certificates of deposit can also be paid through coupons issued with a certain periodicity or in a single solution, at the contractual maturity.

Certificates of Deposit are suitable for those looking for a relatively safe, low-risk investment, with a stable and predictable return. However, it is important to carefully evaluate the interest rate offered, and the associated costs and consider the investment alternatives available before making a decision.

Features of certificates of deposit

Certificates of deposit represent contracts between the investor and the issuing bank, in which the investor gives the sum of money to the bank and in exchange receives a certificate certifying his right to reimbursement of the principal plus interest accrued at maturity.

Let’s see the characteristics of these contracts below:

• Versatility: banks that issue certificates of deposit offer customers various lock-in deadlines, from a minimum of three months to a maximum of five years;
• Possibility of opting for the payment of the interest accrued at the end of the bond’s expiry or by issuing periodic coupons;
• Protection of invested capital: the invested capital does not lose value and, upon expiry of the restriction, the customer receives the initially restricted sum together with the related interest accrued;
• Guarantee of the Interbank Deposit Protection Fund: each depositor enjoys the guarantee provided by this fund for the protection of deposits up to 100,000 euros;
• Possibility to release the deposited sum: if a customer needs liquidity before the deadline, the bank will return the initially restricted sum, retaining the interest amounts paid up to that point.

Types of CDs

Certificates of deposit can be divided into five types:

• At a fixed rate, the capital is remunerated at a fixed, predetermined, and constant rate for the entire duration of the bond,
• Fixed rate with final premium, in addition to the characteristics of the first type, at maturity the customer also receives a coupon as a final premium,
• At a fixed rate “one coupon”, the capital is remunerated at a fixed rate with interest paid in a single solution on the maturity date,
• At an increasing fixed rate, or step-up, with periodic payment of coupons,
• At a variable rate, the capital is remunerated based on the trend over time of a parameter (e.g. 12-month Euribor) increased by a spread.

Advantages of Certificates of Deposit

Certificates of Deposit offer several benefits that make them an attractive option for investors looking for stability and safe returns. Listed below are some of the key benefits of certificates of deposit:

1. Safety of capital: certificates of deposit are considered safe financial instruments since the invested capital is protected by the guarantees of the Interbank Deposit Protection Fund or other similar protection mechanisms. This means that, in the event of insolvency of the issuing bank, investors can obtain reimbursement of their capital up to a certain threshold established by law.
2. Guaranteed interest rate: Certificates of deposit offer a fixed interest rate that is agreed upon at the start of the investment. This allows investors to know exactly what the return on their investment will be during the lock-in period.
3. Versatility in Maturities: Banks that issue certificates of deposit offer a variety of maturities, allowing investors to choose the term that best suits their financial needs. This allows for greater flexibility in short, medium or long-term investment planning.
4. Liquidity: Despite the investment period constraint, certificates of deposit offer a certain degree of liquidity. In most cases, investors have the option to release the sum deposited before maturity, although penalties or reductions in accrued interest may apply.
5. Ease of Access: Certificates of deposit are easily accessible at many financial institutions, including traditional banks and online banks. This allows investors to find convenient and competitive options in terms of interest rates and related services.
6. Portfolio Diversification: Certificates of Deposit offer a way to diversify your investment portfolio. Since they are considered low-risk financial instruments, they can be used as a stable and safe component within a broader portfolio, which also includes riskier investment instruments.

Risks of Depositary Receipts

Certificates of Deposit are generally considered safe investments, but there are some risks to consider:

1. Rate risk concerns the impossibility of benefiting from any increases in market rates as well as changes in interest rates, which could influence the value of the certificate on the secondary market. Fixed-rate certificates are more subject to this risk than variable-rate certificates;
2. Liquidity risk refers to the lack of possibility of early redemption;
3. Risk of destruction of the security applies to bearer certificates, which can be lost without the possibility of reimbursement. To avoid this risk it is advisable to choose certificates that can be deposited in a securities dossier or securities depository;
4. Risk relating to the debtor concerns the possibility that the issuing bank goes bankrupt or encounters difficulties in repayment, but it is possible to resort to the Interbank Guarantee Fund for reimbursement of up to 100,000 euros.

Differences with other financial instruments

Certificates of Deposit are investment tools that offer customers the ability to manage and profit from their savings. Although they can be compared to deposit accounts and Bots, certificates of deposit have specific characteristics and notable differences.

Difference between certificate of deposit and deposit account

Certificates of deposit are part of the direct collection of banks since they are instruments issued directly by the institutions.

The main difference between certificates of deposit and deposit accounts is that the former are restricted non-transferable registered securities, for which total or partial release of the sum invested while the latter can generally be liquidated at any time by paying a penalty.

Certificates of deposit do not have subscription costs but may have a possible cost upon termination. With certificates of deposit, no further deposits can be made after issuance. The investor pays a stamp duty of 0.20% and a withholding tax of 26% on interest. In some cases, it is possible to release the deposit before maturity, but the bank retains the interest paid up to that point and calculates a lower fixed rate.

The choice between the two depends on the individual needs of the customer, the desire for immediate liquidity, or more stable and guaranteed returns over time.

Difference between certificate of deposit and bonds

Certificates of deposit and bonds are both financial instruments used to invest your capital, but they have some significant differences:

• Certificates of deposit are issued by banks, offer a fixed interest rate, and have a predefined maturity. They are less liquid, but considered safer thanks to the guarantees of the Interbank Deposit Protection Fund;
• Bonds, on the other hand, can be issued by different entities, and have variable returns and longer maturities. They are more liquid, but carry a greater risk of issuer insolvency.

How to invest in certificates of deposit

To invest in certificates of deposit, you need to research the different options available at banks and financial institutions. Comparing the interest rates offered, terms and conditions can help you find the best opportunity.

Typically you will need to open an account with the bank or financial institution that issues the certificates and proceed with the purchase of the selected certificate of deposit. Upon maturity of the certificate of deposit, you will be entitled to a refund of the capital invested together with the accrued interest. You can decide whether to reinvest the funds in a new certificate or use them for other purposes.

How much does a certificate of deposit yield?

The yields of certificates of deposit vary from bank to bank with yields from 4% for the shortest term maturities (24 months) up to 5.5% net for those with a 60-month lock.

Original article published on Money.it Italy 2023-07-04 06:53:03. Original title: Certificati di deposito: cosa sono? Guida completa