Negotiable Certificates of Deposit

For short-term instruments that provide safety and liquidity, Negotiable Certificates of Deposit, or NCDs, are among the few attractive investments. Unlike traditional CDs, which lock your money until maturity, the NCD allows you to sell the certificate in the secondary market before maturity. 

What is a Negotiable Certificate of Deposit? 

A negotiable certificate of deposit, also known as an NCD, is a type of time deposit available from financial institutions that the investor can buy and sell on the secondary market. Traditional certificates of deposit require that the investor hold the deposit until maturity. In the case of a negotiable CD, an investor can attain liquidity by selling the instrument before maturity. 

Most NCDs require a minimum investment of at least US$100,000, so they are used by institutional investors. A person can purchase NCDs whenever she has the needed capital or when the market is open. These are time deposits carrying a fixed interest rate for a definite period. 

Key Features of a Negotiable Certificate of Deposit are: 

• Negotiability: NCDs differ from traditional CDs in that they are negotiable and can be sold into the secondary market before maturity. 

• Large Denominations: This paper generally comes in big denominations starting from US$ 100,000. 

• Short-term Investment: This investment tool is short-term, ranging from a minimum of weeks to a maximum of a year. 

• Fixed or Floating Interest Rates: These can be fixed or pegged to a floating benchmark, such as LIBOR. 

Understanding Negotiable Certificates of Deposit (NCDs) 

NCDs are interest-bearing debt securities that banks issue to raise capital. They provide a safe avenue for investors to park their funds for some time and earn interest. The holder’s most valuable feature or advantage about NCDs is that they are negotiable, and he may sell the certificate in the secondary market rather than hold it until its maturity date. 

Trading in the Secondary Market: 

NCDs are transferable and traded among institutional investors in the secondary market. This trading feature provides liquidity, a significant plus compared to traditional CDs, which generally require investors to keep their money tied up until maturity. In any case, the price at which an NCD is sold may show fluctuations in interest rate and market conditions at the time of sale. 

Interest Rates: 

Because of their larger denominations and the added risk of their negotiability, NCDs pay competitive interest rates, often well above those paid by savings accounts and traditional CDs. The interest rate may be fixed, ensuring a return locked in for the investment term or floating, changing with market conditions, such as up and down changes in the LIBOR rate. 

However, these carry some amount of risk. There are two types of risks associated with NCDs: interest rate risk, which is the possibility of the interest rate going up, in which case the value of the NCD would fall. Liquidity risk is due to various market conditions, and selling the NCD at a good enough price becomes difficult. Callable NCDs also run the risk that the issuer may call the deposit, thereby obstructing the returns anticipated to be earned by the investor. 

Types of Negotiable Certificates of Deposit NCDs 

Several variants of Negotiable Certificates of Deposit (NCDs) are available, designed to suit investor preferences and market conditions.  

1. Fixed Rate NCDs: This type of NCD has a base amount payable only during the investment period. Investors invest in floating-rate NCDs when they feel that there is a possibility of an interest rate hike shortly and want to take advantage of this. However, in this type of NCD, the investor is at risk from the market since the return is not guaranteed. 
2. Floating-rate NCDs: These have floating interest rates benchmarked on a reference rate, say LIBOR. If the benchmark rate goes up, then the interest paid on the NCD also goes up, giving returns that are probably higher. But if the rate goes down, returns decline. Floating-rate NCDs are ideal for those investors who expect interest rates to rise during the investment period.  
3. Callable NCDs: In callable NCDs, the issuer can recall the deposit before maturity. While callable NCDs pay a high interest rate to compensate for this call risk, investors typically face uncertainty over the loss of future interest when an issuer of these instruments exercises the early call option in these types of NCDs. For example, a bank would make an NCD callable at 5%, but if the interest rates fell considerably, they would call the NCD, which means the investor would be made to reinvest at the lower rate.  
4. Non-Callable NCDs: Non-callable NCDs ensure no early redemption can occur, thus giving the investor complete peace of mind for their long-term security. However, there is a catch: generally, non-callable NCDs pay a lower interest rate than callable NCDs because there is no risk of early redemption 

Comparison with other Investments 

NCDs provide an attractive trade-off between safety and return and are in demand among investors. Let’s compare NCDs with other joint investments: 

Traditional CDs: Although both NCDs and traditional CDs are time deposits, traditional CDs do not have negotiability. That is, since a conventional CD is purchased, the investor needs to hold on to it until maturity, which causes a lack of liquidity. On the other hand, NCDs are marketable in the secondary market and, hence, more flexible. Because of their large denomination and marketability, NCDs provide a slightly higher interest rate than other CDs. 

Treasury Bills: T-bills are government securities that are short-term in nature and considered among the safest investments. However, their returns are generally low compared to NCDs. NCDs, on the other hand, are relatively safe because banks issue them. They yield high returns compared to T-Bills, making them a better option for every investor who wants returns that are high enough. 

Corporate Bonds: However, corporate bonds yield more than NCDs, which have a greater credit risk because the chances of a company default are higher than those of banks. The NCD is safer due to its backing by any financial institution, while its yield is usually lower than those provided by corporate bonds. 

Money Market Funds: Money market funds invest in very short-term, high-quality securities but provide immediate liquidity. Returns usually are lower than those given by the NCDs. In that respect, while money market funds offer easy accessibility and immediate liquidity, a negotiable certificate of deposit provides the assurance of fixed returns and slightly higher yields. 

Examples of Negotiable Certificates of Deposit (NCDs) 

Some examples of how NCDs are applied in real situations: 

Fixed-Rate NCD: 

Suppose an investor invests in a fixed-rate, US$ 500,000 NCD, offered by Bank X for six months with a 3% interest rate. The investor can be assured of earning precisely 3% of the investment during the next six months. In exchange, the investor enjoys stability and predictability of income. 

Floating-Rate NCD:  

An investor buys a US$1,000,000 floating-rate NCD from Bank Y. The initial interest rate is pegged at 2.5% plus LIBOR. Because LIBOR increases, the interest on the NCD is reset upward, which could result in higher returns to the investor if favourable market conditions exist for a rate increase. 

Callable NCD Example: 

An investor buys a US$200,000 Bank Z callable NCD that pays interest of 4% per year, but Bank Z has the right to call the NCD in two years. For instance, if the interest rates fall that second year, then the bank can call the NCD early and pay the principal back to the investor, who subsequently loses the chance to enjoy higher future interest income. 

Frequently Asked Questions