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Pros and Cons of Market-Linked CDs

Portfolio Diversification

Due to the recent economic downturn, you may be hesitant to re-enter the stock market for fear of losing money on your investments. Fortunately, there is a fairly new hybrid investment, known as a market-linked CD, that addresses this issue.

Many investors are still not familiar with this type of certificate of deposit because they aren’t as prevalent as more traditional CDs and similar deposit accounts. As Leonard Sloane of the New York Times explains, “only a few financial institutions have created such certificates, [though] many others are testing or considering similar products.”

With their popularity steadily growing, you may wish to invest in one as well. However, you should be aware of several key characteristics that could possibly dissuade you from doing so. Consider the following pros and cons of investing in market-linked, or equity-linked CDs.

Pros of Market-Linked CDs

  • Potential high return. Unlike traditional fixed-rate CDs, this type of certificate of deposit earns an interest rate that is tied to a fluctuating market index. Therefore, when the market does well, so does your investment. Some of the best CD rates are offered by market-linked CDs, as evidenced by any market-linked CD rates comparison.
  • Diversification. One of the most important rules of investing is to diversify your assets. The “eggs in one basket” approach not only increases your risk of losing money, but prevents you from participating in several different opportunities to obtain favorable returns at the same time. You can easily diversify your portfolio among several securities with one index CD account.
  • Market participation combined with risk aversion. If you invest in an array of stocks, bonds and mutual funds, there is nothing preventing you from losing every penny should markets plummet. However, most issuers of market-linked CDs offer principle protection. This means that your initial investment is protected from downturns in the market, but only when you hold the CD until maturity. Early withdrawal typically eliminates any possible earnings, as discussed below.
  • FDIC insurance. There are a few exceptions, but almost all market-linked CDs are protected by the FDIC, up to the maximum of $250,000 until 2014. However, do note that only the principle amount is insured, not the interest you earn.

Cons of Market-Linked CDs

  • Extreme early withdrawal penalties. You probably already know that you aren’t supposed to withdraw money from a CD before it matures. However, the special nature of an index CD makes early withdrawal all the more problematic and will result in a large fee that cancels out any potential return.
  • Higher tax rate. Market-linked CDs are not taxed the same as traditional CDs and other deposit accounts because they invest in the market. Taxation is a much more complicated and expensive process. Interest must be declared annually (even when it is only paid at maturity) and is taxed as ordinary income. Holding a market-linked CD in a tax-deferred account, such as an IRA, can help you avoid paying high taxes on your earnings.
  • Capped returns. Though a strong market increases the earning potential of your market-linked CD, there is usually a maximum return per year, or interest cap. For example, if the market increases 20 percent, and the participation rate is 80 percent, your return would theoretically be 16 percent (20 percent of 80 percent). However, if a 10 percent cap is placed on your earning potential, that will be your return on your CD instead.
  • There is still risk. Your investment in a market-linked CD is still vulnerable to market volatility. If the index it’s tied to remains flat or declines, you have the possibility of earning absolutely nothing.

Please consider these factors carefully before deciding whether or not to invest in a market, equity or index-linked certificate of deposit. Always review the specific terms of a particular CD prior to investment. You may wish to consult a financial or tax professional for more information.

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