Alternatives to Certificates of Deposit

There are plenty of alternatives to CDs, but many involve more risk.finanzen, dollar image by mbs from Fotolia.com

Certificates of deposit, or CDs, have been a mainstay investment for individuals seeking modest returns with little risk. Backed by the Federal Deposit Insurance Corporation (FDIC), CDs issued by banks are considered nearly risk free. But when interest rates fall, as they did during the most recent economic downturn, the returns on CDs may not even keep pace with inflation. In June 2010, for example, CD rates were in the range of 1 to 2 percent, according to bankrate.com, while inflation hovered around 2 percent. As a result, many investors began abandoning CDs in favor of higher yield investments, according to the New York Better Business Bureau. There are plenty of alternatives to CDs, but investors should keep in mind many of them involve more risk. These alternatives should be considered in the context of investment goals, income needs and timing.

"Blue Chip" Stocks

During economic downturns, the stock value of so-called blue chips--big, reliable and historically sound companies--often continue to grow or at least maintain their value. Stock brokers often quote 20 percent returns on the highest-performing blue chips, a significantly higher yield than CDs. Historically, blue chips have far outpaced inflation and CDs. Between 1950 and Jan. 1 2010, for example, the value of the Standard & Poor's 500, an index of large-cap equities, grew at an average inflation-adjusted rate of 8.71 percent. But investors should remember past performance is no guarantee of future results. Stocks are much riskier than CDs. While CDs are insured, investors can lose principal investing in the stock market.

Mutual funds minimize the risk of investing in the stock market by diversifying the types of equities you are buying. A mutual fund manager will buy and sell a wide variety of securities that become part of the fund's portfolio. Each investor's return depends on the overall performance of the portfolio. Risk is reduced because poor performance of any one stock can be offset by high yields from other securities. But in exchange for the reduced risk, mutual fund investors are also unlikely to get the extremely high rate of return that a single, successful stock may yield. Another downside is mutual fund managers often collect a fee.

Corporate bonds are a popular alternative because they often pay better returns than CDs. These bonds are essentially loans to a company at a fixed interest rate and maturity date. Companies issue bonds to finance construction of facilities or for operation cash flow. But, like the companies that issue them, they vary greatly in risk and value. They range from risky "junk" bonds to safer investment grade bonds issued by "blue chip" companies. They also differ in bond structure, coupon rates, maturity dates, credit quality and industry exposure. There is always the risk that a corporate bond will decrease in value. When interest rates go up, for example, bond prices tend to fall. In recent years, a number of "junk" bonds have defaulted, leaving investors with a fraction of their original money.

Collateralized mortgage obligations (CMOs) are bundles of home loans, many backed by the Federal Housing Administration or the Veterans Administration. Holders of these mortgage-backed certificates receive their share of the homeowners' mortgage payments. These investments are touted as CD alternatives because of their higher yields and because you can't lose principal if the CMO is backed by government-guaranteed mortgages. But they are complex and, in many cases, institutional investors have better access to information about them than individuals. This can make it difficult to compete for higher grade CMOs.

Like CDs, annuities are considered low-risk investments. Fixed annuities are offered by life insurance companies and offer a fixed rate of return over a period of time ranging from one to five years, regardless of the market. As of mid-2010, rates ranged from 3 percent to 4.75 percent. Unlike CDs, investors are often able to access a certain percentage of the annuity before it matures--usually 10 percent per year. But because they are issued by insurance companies, annuities are backed by the company's financial stability and strength. You can learn about the company's financial strength by requesting the findings of an independent rating company such as Moody's. A deferred fixed annuity is a long-term option, often used to accumulate money for retirement or to protect money already saved after retirement. In later years, it is often more flexible for accessing invested money and can even be used to provide a legacy to children.

U.S. Savings Bonds, essentially loans to the federal government at a fixed interest rate and maturity date, have become more popular since the economic downturn. They are safe because they are backed by the government, and as of mid-2010, they offered relatively high rates of return. The yield for Series EE Bonds held for five years was 6 percent, significantly higher than government insured bank CDs. They are also exempt from state taxes. Savings bonds can come with other tax advantages, too. The returns for certain bonds are tax-exempt if they are used to pay for college. The money invested in a bond is usually accessible but will not reach full value until the maturity date.