Market-linked certificates of deposit… not your grandfather’s certificates of deposits

The ABCs of CDs

Certificates of deposits (CD) are low-risk, but low-reward, options for investing money. Banks and credit unions sell CDs with maturity dates that are weeks or a decade down the road. When the maturity date comes, you receive the amount of your investment (principal) back plus interest. The interest payment you receive is based on the rate that was offered when you purchased the CD. There should never be any surprises — of the happy or shocking variety.

Market-linked CDs (MLCDs) offer up a wrinkle

The fundamentals of MLCDs are the same. You purchase a certificate for a pre-defined period, commonly for five years. In exchange for leaving those funds with the bank, you receive payments of interest.

Here’s the wrinkle: the payments you receive are not based on an interest rate agreed-upon upfront. Instead, they’re based on the changes to an agreed-upon index. The $10,000 MLCD you purchase for ten years, for example, might pay a return based on the move to the Standard & Poors 500 index over that period.

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What are some things to keep in mind when considering investing in an MLCD?

Restrictions on an early withdrawal

Traditional CDs are subject to penalties if you withdraw your money before the CD matures. The restrictions are even more significant when it comes to an MLCD. Many stock market-linked MLCDs do not allow early withdrawal without the bank’s consent. If early withdrawals are permitted, penalties will be significant. Investing in an MLCD may not be a good option if there’s a chance you’ll need your principal before the maturity date comes around.

How the payoff is determined

The payout is usually calculated by averaging the closing price of the index (the S&P 500 in our example) over a defined period of time, perhaps six months or a year. By using an average of the value of the S&P 500 index, you’re protected from the troughs when the index drops but also denied the full benefit of the peaks when the index spikes.

Limited upside

MLCDs limit the potential return on your investment. They do this in two ways: by applying a participation rate; and by imposing a hard cap.

Participation rate: The full amount of your principal won’t “participate” in the growth of the index. Your investment is subject to a participation rate. If your MLCD participates at 90% and the linked index increases by 10%, you won’t see a 10% payoff. You’ll only receive 90% of that or 9%.

Hard caps: MLCDs impose ceilings on the total amount paid out to investors. If that ceiling is set at a 12% return but the index increases by 20%, the investor misses out on a large portion of that growth.

Here’s the wrinkle: the payments you receive are not based on an interest rate agreed-upon upfront. Instead, they’re based on the changes to an agreed-upon index.

The “T” word

Income generated by MLCDs is often treated by the Internal Revenue Service as income as opposed to dividends or capital gains, though not universally so. Income, capital gains, and dividends are taxed at different rates, so investors should read the MLCD’s disclosure statement carefully. It should describe how returns will be reported.

Cancelation

MLCDs can often be canceled by the bank that sells them to investors. Trigger points for cancelation or “calls” will be defined in the contract, but they could be after specific periods or depend on interest rate levels. When a bank cancels or calls an MLCD, the investor gets back their principal and any earnings to the date of the cancelation or call. But the investor won’t see any future gains beyond the date of the cancelation or call.

Underperformance

A  Wall Street Journal study found that MLCDs underperformed CDs after fees, limits, and other facts were taken into account. The study looked at 147 MLCDs since 2010. It found that 62% of them underperformed non-linked CDs.

None of these factors mean that MLCDs are a good or bad investment. They merely indicate the uniqueness of the product and show that every investment option has advantages and disadvantages.

A deeper dive – related reading from the 101:

Tax season basic: What is taxable income? | Finance 101

Taxation is a factor every investor should consider when choosing between investment options

Riding the ups and downs of high-risk investments: Here’s what to expect | Finance 101

Every investor has different tolerances for risk and volatility. You should understand those risks