UDBS FINANCIAL INSIGHTS: Exploring investment avenues in the Tanzanian economy – Part 5: Certificate of deposit

INVESTORS constantly seek secure avenues for wealth to grow in today’s volatile financial landscapes. We have explored investment in shares, treasury securities, mutual investments, and corporate bonds. Among investment options to add to the basket is the Certificate of Deposit (CD).

With its enticing combination of guaranteed returns and low risk, CDs have become attractive for seasoned investors and those looking to start their investment journey. In this article, we delve into the world of Certificates of Deposits, exploring their benefits, considerations, and why they remain a viable investment opportunity in an uncertain market.

Certificates of Deposits, commonly known as CDs, are financial instruments banks and other financial institutions offer. They function as time deposits, where individuals deposit a fixed sum of money for a specified period, known as the term. During this period, the investor earns interest on their deposit, generally higher than a regular savings account. If an investor wishes to withdraw the fund before maturity, the bank usually penalises them by losing all or part of the interest earned.

One of the most compelling reasons investors choose CDs is their guaranteed returns. Unlike many other investment options, CDs offer a fixed interest rate, ensuring that investors know what they will earn at maturity. This predictability, coupled with the fact that CDs are typically insured by the government up to a certain amount, provides a sense of security for risk-averse individuals.

CDs come with various maturity options, ranging from a few months to several years. The maturity can be customised based on investors’ demand, which allows investors to align their investment goals and time horizons with the appropriate CD term. Short-term CDs are ideal for individuals with immediate cash needs, while longer-term CDs provide an opportunity for higher interest rates and more substantial returns over time. The shorter the maturity, the lower the interest rate that the bank will pay. The benchmark should be the rate earned on treasury security. For example, if 5 years bond is earning 8.6 per cent, you must get at least 8.6 percent for 5 years certificate of deposit (time deposit).

How can a Certificate of Deposit be used to meet investment goals

To avoid penalties for withdrawing funds before maturity, three strategies are used in Certificates of Deposit to meet short-term and long-term investment goals and take advantage of increasing interest rates. These include;

Bullet strategy

With bullet strategy, investors can choose when the fund is needed and plan for several CDs to meet that particular need. Every fund obtained will be invested in CD, which matures on that date. For example, if an investor wants to purchase a home in 2028 (5 years from now), he can invest annually in CDs. In 2023 he will buy 5 years CD; in 2024, he will buy 4 years CD, and so on. All the CDs will mature in 2028 to meet a particular need.

Ladder strategy

With a ladder strategy, an investor allocates the available fund into different maturity CDs, say 1, 2, 3, and 4 years. When the 1 year CD matures, it will be reinvested into 4 years, and the other CDs will have 1, 2, and 3 years to maturity. After another 1 year, the 2years CD will mature and be reinvested in 4 years CD. At all times, an investor will have 4 different maturities. This ensures investors always have liquid and maturing CDs while taking advantage of rising interest rates.

Barbell strategy

In this strategy, an investor chooses between the two extremes, a long-term CD and a short-term CD. The large sum is divided into these two CDs, a large proportion being invested in Long term CD. Once an immediate need arises, the short-term CD can help an investor meet the demand instead of withdrawing from a long-term CD. Once the short-term CD matures, it is reinvested in the short term until the investment horizon is over.

Several commercial banks in Tanzania are offering good deposit rates for fixed deposits. Investors can consider using one of the discussed strategies in allocating the fund into two or more CDs to be liquid and have maturing CD for reinvestment at a higher rate.

Generally, Certificates of Deposit (CD) provide a secure and reliable investment option for individuals seeking stability and guaranteed returns. With their predictable interest rates and depositors-fund insurance, conservative investors have long favored CDs. However, investors must assess their financial needs, consider the CD term that aligns with their goals, and compare rates from different institutions to make informed investment decisions. By incorporating Certificates of Deposits into their investment portfolio, savvy investors can balance security and lucrative returns in today’s ever-changing financial landscape.

Author: Mr Godsaviour Christopher is A PhD candidate at the University of Agder, Norway, and a researcher at the Centre for Banking and Financial Services Research (CBFSR) at UDBS. (godsaviourchristopher@gmail.com and +255753218577)

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