When the marketplace anticipates higher interest rates, it can become increasingly difficult to get members to accept longer-term deposit accounts. At the exact same time, credit unions may be looking for ways to encourage more depositors to lock in for longer terms. One way to encourage depositors is to give them a rate change feature in their account.
Bankrate.com recommends that “investors who may be paralyzed by anticipation of higher rates might want to consider CDs that offer a rate increase as market rates rise. Known by such names as ‘bump-up,’ ‘step-up’ and ‘raise-your-rate,’ these types of CDs are designed for investors who want to capture the additional yield. That advantage comes at a price, however. Rising-rate CDs tend to start out with lower initial rates and the increase might not be guaranteed, especially if market rates don't rise or the CD is callable, which means the issuer can cancel it before its maturity and return your money to you … CDs with rising-rate features can be complex. Make sure you read and understand the rules before you invest.”
We have observed that adding options on time deposits has proved in the past to make time deposits more attractive to depositors. These options are often reserved for medium- to longer-term certificates.
In October 2015 RateWatch released Preparing for a Rising Rate Environment: The Landscape Transformed based on 765 responses from U.S. financial institutions. Of the respondents that said they were developing additional products, 10.95 percent reported that they were developing a “step-up CD.”
In general, time deposits are simple, safe, and predictable. But accounts with rate change options are more complex. As credit unions design these accounts, all possible variations must be considered so unintended consequences are avoided and reputation risk is mitigated.
Scheduled Automatic Rate Increase(s)
The first aspect that must be addressed is the nature of the rate change. Is it a scheduled change or an option given to the member?
A scheduled rate change is a commitment on the part of the financial institution to automatically increase the certificate yield at the designated time or at particular time intervals. The rates are disclosed according to a schedule and the annual percentage yield is calculated over the entire possible holding periods.
If the account does not provide an option for a penalty-free withdrawal before maturity, this promotion provides no real option value, because the maturity value of the account is fixed regardless of the pace of the dividend accrual to the depositor, other than the potential for a slight variation in the magnitude of the early withdrawal compared to a fixed-rate certificate with the same APY. This occurs when the early withdrawal penalty is based on a number of months of interest and the initial interest rates are lower, thereby creating initially lower early withdrawal penalties.
Because the difference in value to the depositor of these accounts compared to a fixed-rate certificate is minimal, a case can be made that these are merely marketing gimmicks. However, accounts that provide penalty-free withdrawals at rate change intervals can provide real value to depositors. Credit unions that provide penalty-free withdrawals at rate change intervals and determine their scheduled rate increases based upon the embedded forward implied yields of their fixed-rate accounts can make a strong case that they are delivering real value to members while not adding materially to their own interest rate risk.
For example, let’s consider a credit union that is currently offering a one-year fixed rate APY of .75 percent and a two year of 1.20 percent. The forward implied yield is calculated by determining the total earnings over two year for the longer one (2.40) and subtracting the total earnings of the shorter one (.75) = 1.65 percent and dividing the result over the remaining term of one year = 1.65 percent.
This makes a good benchmark for the yield in the second year of the automatic rate change. If the credit union is not trying to extract value for the optionality, then .75 percent could be advertised as the interest rate for the first year and 1.65 percent for the second year with a blended APY of 1.20 percent. At the end of two years, the rate-change certificate and the fixed-rate certificate would have the same net account values.
To extract some value for the embedded optionality, the rate could be lowered in the initial term and added to the rate on the last term, leaving the APY alone. Alternatively, one or both rates could be lowered, and the APY could be adjusted downward on the basis of the advantages of the penalty-free options at the rate change dates compared to the fixed-rate certificates.
Optional Rate Changes
When structured as an option granted to the depositor, the nature of the option needs to be clearly defined and stated explicitly in the account disclosure in regards to:
- the number of times the rate change option can be exercised;
- the index that determines the optional future interest rate and
- the impact of term maturities and renewals on the option.
Clearly, a one-time option is considerably less valuable to depositors than multiple-chance options because depositors only get one chance to upgrade their interest rate. The process of timing the rate increase for maximum impact has a natural consequence of causing hesitation. Unless rates are rising aggressively, most one-time options can be reasonably expected to expire without members exercising their option.
The future interest rates the depositor can select will typically be defined as the then-current rate offering on either the 1) same term as the original term to maturity of the account or 2) the term of a currently offered account closest to the remaining maturity of the depositor’s account.
Noting that the credit union will consistently be positioned to manage current offering rates, there is very little risk to a certificate issuer if it allows depositors to trade up to the currently offered yield on the closest remaining term. There is significantly more risk if the original term rate is used as the future rate index.
We recommend all accounts be automatically renewable. The availability of the option can extend through one of the following (listed from least valuable to most valuable to depositors):
- only the first term to maturity regardless of utilization during the first term;
- the first use, which may include subsequent renewal periods; and
- each term as the option resets for usage by the customer for each subsequent term regardless of utilization in any prior term.
There is nothing about rate change certificates that necessitates the need for call features. However, the higher the interest rate accruals, the more likely the credit union will desire to use any call features embedded in their certificates. Depositors get excited about the higher yields, but often claim they did not understand what they had agreed to when the issuer subsequently calls the certificate before maturity and leaves the depositor to reinvest at disadvantageous interest rates. We discourage the use of call options because of the negative impressions created when depositors are adversely surprised.
It is easy to find financial institutions issuing rate change certificates. A little research will reveal a spectrum of approaches used in the marketplace using the aspects highlighted here. Your member service representatives may find the details of your research to be valuable when members try to compare your offerings to others. The warnings about complexity of some offers above may be highly applicable. We encourage you to duly consider the structures you assemble in light of your funding and member experience goals.