What Is a Callable Certificate of Deposit?

A callable certificate of deposit is a certificate of deposit (CD) that allows the issuer (not the purchaser) to redeem the CD after a specified period of time. The issuer is likely to redeem the certificate of deposit when interest rates decline. The purchaser's CD could end upon maturity, upon redemption by the issuer, or upon the purchaser's sale of the CD on the secondary market. Like all CDs, a callable certificate of deposit presents a significant lock-in risk to purchasers who might need the funds prior to maturity.

An NASD complaint made on February 1, 2005 against Andrew J. Patton, who worked in various brokerage firms, gives a concise overview of long-term callable certificates of deposit:

OVERVIEW OF LONG-TERM CALLABLE CERTIFICATES OF DEPOSIT

2. This case arises from Patton's sale of long-term callable certificates of deposit ("CDs"). These callable CDs allowed the issuer, not the purchaser, to redeem the CD after a specified period of time. Typically, the issuer could redeem the CD on each anniversary date of the purchase. Issuers tend to exercise the call option when interest rates fall. When the issuer calls a CD, the issuer returns the principal amount invested to the customer, and the customer keeps any accrued interest.

3. If a customer wished to redeem a callable CD prior to maturity or call by the issuer, the customer's only option was to sell the CD on the secondary market. The price paid to the customer in the secondary market was contingent on supply and demand and prevailing interest rates. This presented a significant risk for customers who needed the funds prior to maturity. In 1997 and 1998, many CDs were called because interest rates were declining. But later, when interest rates were increasing, the banks did not call the CDs. In many instances, during 1999 through 2000, secondary market transactions occurred at prices well below the original face amount of the CD. This case focuses on the sales made by Patton in 1999 and 2000 in which Patton made misrepresentations to customers concerning the redemption value of CDs.

Why would an issuer redeem a callable certificate of deposit when interest rates decline? Because the issuer can get out of a CD that provides the purchaser an interest rate that has become higher than the prevailing rates. The issuer prefers to pay the lowest interest rate possible on a CD.

Unfortunately for the purchaser, when interest rates decline, the issuer will probably redeem the CD; and when interest rates rise, the issuer will not call the CD, and the purchaser's only exist options are to wait until maturity (with the now below-market interest rate) or attempt to sell the CD at the secondary market at a discounted price. (The price of CD gets discounted when the interest rate it provides is below prevailing rates.)

In general, CDs are considered safe investments because the capital that is invested is not at risk. But CDs are typically not prudent investments for people who are likely to need the funds prior to maturity.  For example, someone who wants to become eligible for Medicaid by transferring assets (outright to a trust) should not invest in a CD.

A callable CD differs from an ordinary CD because a purchaser can redeem a callable CD  prior to maturity only by selling it on the secondary market, while a purchaser can redeem an ordinary CD prior to maturity by paying the issuer a percent (such as 1/2 to 1%) of the principal. The first cause of complaint by NASD against Patton goes precisely to this point.

5. Patton falsely represented to customers PM, BM, and CM that the customers could redeem the callable CDs with a penalty of 1/2 to 1% of the principal after the customers held the CDs for one year. . . .

6. Patton's representations were false, because the market value bore no relation to the penalties quoted by Patton.

7. If a customer wished to redeem a callable CD prior to maturity or call by the issuer, the customer's only option was to sell the CD on the secondary market.

8. Because interest rates were rising at the time PM, BM, and CM redeemed their CDs, the customers suffered losses far in excess of the 1/2 to 1% redemption penalty quoted by Patton.

Another NASD complaint made on May 20, 2005 against James A. Swanke and Colin P. Collea gives a detailed discussion of callable certificates of deposit:

3. During the period from at least January 1998 through approximately December 2000, [U.S. Bancorp Investments, Inc. ("USBI")] and its representatives offered and sold brokered Callable Certificates of Deposit ("CCDs") lo the public. During the relevant time period, USBI's traders purchased large blocks of DTC-eligible CCDs into USBI's inventory account at a price typically one percent below par. The traders then broke the blocks up into smaller denominations for sale to customers. Once broken into smaller denominations, USBI's fixed-income trading desk in Minneapolis, Minnesota offered the product to USBI's brokers, who were typically located in bank branch locations. In most cases, when the trading desk purchased CCDs, the traders sent "inventory sheets" which summarized current holdings and key characteristics (the rate and features) of the CCDs to USBI's brokers nationwide via facsimile.

4. USBI marketed the CCDs to customers primarily through referrals from US Bank employees. When customers sought information about traditional CDs from US Bank, they were referred to the USBI broker located in the branch for information regarding higher-yielding CCDs.

5. The terms of the CCDs were usually for extended maturities of 15 or 20 years. These products typically offered customers a higher interest rate for the first year, and the rate "stepped down" to a lower rate (usually 1% to 2% lower) for the remaining term. The CCDs varied in terms of how often they paid interest; there was a monthly payout on some CCDs, and a semi-annual payout on others. The CCDs also offered a death put redemption clause, which meant that in the event the CCD holder died, the CCD was redeemable for its full (par) value by the heirs of the deceased. Most of the CCDs were callable by the issuing institutions after a one-year period, and then for every six months thereafter. The CCDs were FDIC-insured up to $100,000 per institution.

6. A customer could redeem his or her CCD prior to maturity only by selling the CCD in the secondary market maintained by USBI. The price that the customer received at the time of liquidation could be significantly less than the customer's original principal.

7.  In 1998, the issuing banks called many of the previously issued CCDs because interest rates were declining. However, issuing banks ceased calling CCDS in early 1999, when interest rates began to rise.