Some investors find market-linked CDs, a relative newcomer to the world of time-deposit accounts, to be highly appealing. One of the most enticing characteristics of this structured investment is its ability to allow investors to access some of the best CD rates available — without any risk to the principal, should markets decline. Another is that like traditional CDs, market-linked CDs are FDIC-insured.
Before you buy this type of CD, know that market-linked certificates of deposit are complicated. Review the following information to gain an understanding of market-linked CDs to decide if they’re right for your investment strategy.
What Is a Market-Linked CD?
A market-linked CD is a CD that’s linked to the performance of one or more securities or market indexes, such as bond indexes, the Dow Jones industrial average or Standard & Poor’s 500 index. Several other common terms refer to this type of investment, including:
- Equity-linked CD
- Market-indexed CD
- Structured CD
- Index CD
How Market-Linked CDs Work
Market-linked CD rates and performance depend on the performance of the linked market or index. As the market goes up, so does the CD’s potential return. Market-linked CDs guarantee a base return, but if the market does well you’ll earn more — and if the market underperforms, your indexed CD might earn nothing at all.
Important Market-Linked CD Terms
Market-linked CDs have a lot of terms associated with them. To help you understand MLCD lingo better, review the following terms:
- Participation rate: The percentage at which a market-linked CD’s annual return will correspond to the performance of the index to which it is tied is called the participation rate. For example, an index sees a 15 percent gain, but the CD linked to it has a participation rate of 75 percent, meaning the CD will produce a return of 11.25 percent, which is 75 percent of 15 percent. A CD’s participation rate can be more or less than 100 percent.
- Interest cap: To protect a financial institution from paying out an exorbitant amount of interest earned, a cap is often placed on how much interest an investor can earn. Consider again the previous example: If the market-linked CD had an interest cap of 10 percent, that’s the return it would earn, even though it technically should have earned 11.25 percent.
- Call risk: Some market-linked CDs have a call feature that allows the issuing institution to redeem the CD before it matures. The call price determines how much interest the investor earns, which might be less than if he held the CD longer or until its maturity date.
Calculating the Return on Market-Linked CDs
It isn’t difficult to calculate the return on a market-linked CD. Use one of the following two methods:
- Point-to-point: The starting point is the value of the index when the CD is issued. The ending point is the value of that same index just before maturity. The return on the market-linked CD is the difference, or a percentage of the difference, depending on the participation rate.
Average: Rather than calculating the return based on a starting and ending point, the values of the index along several observation points, or dates, are averaged.
Risks of Market-Linked CDs
Like traditional CDs, a market-linked CD comes with FDIC insurance and you are guaranteed to get your principal back when it matures. Although market-linked CDs can be a good investment for people who are risk-averse, want higher returns than traditional CDs offer and do not need current liquidity, they still come with risk factors.
The risks associated with market-linked CDs make them a little less enticing, according to Tim Courtney, CIO of Exencial Wealth Advisors, a Registered Investment Advisor firm.
“Market-linked CDs are fully protected on the downside, so regardless of how much the market loses, your principal is locked in,” Courtney said. “But on the upside, the market return is always capped somehow. Either dividends are excluded or there is a maximum return of say, 5 percent or 10 percent. Make no mistake — the odds you are going to run into a cap on returns are pretty high.”
And the risk of that might be too much for you because most years the markets return more than 5 percent, said Courtney.
Additionally, it can be difficult to get your money back before the term is up, according to Courtney. “If you buy a bond or bond fund, you can find a buyer relatively easily. But to find a seller ahead of time with these assets, you need to go to a secondary market where you will most likely have a hard time finding a buyer that would pay you fair value,” he said. “If you are going to have liquidity, you will likely have to take a pay cut.”
Pros of Market-Linked CDs
As with any other investment, market-linked CDs offer advantages. Understand the pros of this kind of CD investment, so you can determine if it’s right for you.
- Potential big returns: When the market does well, you get the guaranteed return plus a bonus from the market.
- Convenient: A market-linked CD is designed to help protect you against market risk losses if you keep it until it matures.
Return diversification: You receive interest exposure to a variety of markets, such as commodities, currencies and domestic and international equities.
Find Out: Why You Should Invest in a CD Account
Cons of Market-Linked CDs
The downsides of market-linked CDs might influence your choice. Decide if any of these are deal breakers.
- No early withdrawal: Typically, you cannot access your market-linked CD account balance until it matures, so if you think you might need the money before then, this might not be the investment for you.
- Zero earnings: It’s possible you will earn zero interest during an economic downturn.
- Tax implications: This investment has special tax implications. For example, you might have to pay taxes on phantom income from the CD, which means you’ll be paying tax on the interest it earned but that you didn’t receive.
Market-Linked CD FAQ
You still might have some questions regarding this financial product. Review these common questions — and answers — associated with market-linked CDs.
When will my CD mature?
Index-linked CDs are intended for long-term commitments of up to 20 years — unlike traditional CDs, which typically require a commitment from three months to five years.
Can my bank redeem my CD before it matures?
Some market-linked CDs have “call” features that give the bank the right to close the account early without paying a penalty. The bank would likely use the call option when interest rates fall.
When do I receive interest?
You might accrue interest only when your CD matures. That said, you might be required to include interest income in your taxable income each year that you receive a Form 1099-INT from the issuing bank, even if you weren’t paid interest during that year but will receive it when the CD matures. When you pay tax on interest that you’ve earned but not collected, it is known as “phantom income.”
Are there penalties for early withdrawals?
Most market-linked CDs do not allow for early withdrawal. Although, some indexed CDs might enable a deceased depositor’s survivors to redeem the full value early without paying a penalty, and sometimes you can sell the CD to other investors on the secondary market.
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