Sunday, 25 August 2019

Market-Linked CDs: What They Are and If They Are Right for You

There are only so many low-risk saving options that keep your money safe and also provide a nice return. High-yield savings accounts and certificates of deposit (CDs) are the most common ways to grow your funds without worrying about losing principal. Meanwhile, the stock market offers the possibility of higher returns in exchange for much greater risk. What if there were a way to access the richer returns of public markets together with the low-risk security of a CD?

Market-linked CDs are designed to address this very need. With these types of CDs, your principal investment gets the security of a traditional CD as well as the possibility of extra gains when the stock market outperforms. Sounds great, right? Beware, market-linked CDs are somewhat difficult to understand. Read on to learn all the details.

What is a market-linked CD?

Also known as index-linked or equity-linked CDs, market-linked CDs are certificates of deposit with variable interest rates, determined by the stock market. While a conventional CD offers a set interest rate for the term of the deposit, a market-linked CD’s rate of return fluctuates over its term.

The rate of return on a market-linked CD is dictated by the performance of a stock index like the S&P 500, by a basket of individual stocks, or by a combination of indices and stocks. If the underlying index or stocks perform well, the amount you make from these CDs rises. But if they do poorly, you make less — and in some cases your rate of return can go to zero.

“Market-linked CDs are getting more interest because of volatile markets,” says Tom Balcom, founder of 1650 Wealth Management, a Florida-based financial advisor. “It's a product that at certain times is more desirable for investors.”

These CDs are usually offered for a term of at least five years, with some terms even going out to 20 years. Similar to a conventional CD, investors will be charged a penalty for early withdrawals. However, market-linked CDs are “callable,” which means the issuing bank can choose to redeem it before its maturity date.

How do you determine your rate of return on market-linked CDs?

It can be challenging to understand the total rate of return available from a market-linked CD. While the amount you earn is determined by the performance of an underlying index or group of stocks, there are two limitations on your rate of return: the participation rate and the interest rate cap.

  • Participation rate: Your annual rate of return is on a market-rate CD can be restricted to a percentage of the gain in the underlying index or basket of stocks. The participation rate describes this percentage. If a market-rate CD is based on the S&P 500, which sees a 15% gain in one year, and the certificate has a participation rate of 75%, the CD produces a return of 11.25%, or 75% of 15%. Alternatively, a 100% participation rate would give you the whole 15% gain in one year.
  • Interest cap: The rate of return on market-rate CDs can be subject to an annual interest rate cap. If the S&P 500 gains 15% in one year, but the interest cap on a market-rate CD based on this index is 10%, then the CD would only return 10% — even though the S&P 500 gained 15%.

As we all know, stock markets go down as well as up. Losses in indices or stocks on which a market-rate CD are based do not touch the principal investment. However, stock losses mean that your rate of return can be zero. In cases like this, you would have lost out on the opportunity to invest the same money in another investment, like a conventional fixed-rate CD, with a guaranteed return over its term.

Your total return on a market-linked CD is calculated using one of two methods. The point-to-point method looks at the starting value of the underlying index or basket of stocks when the CD is issued and their ending value at maturity. The difference between the two numbers will indicate your return rate — modified by the participation rate and any interest rate cap. The average method averages the value of the index or basket of stocks on regular dates throughout the term of the CD  — also modified by the participation rate and any interest rate cap.

Pros and cons of market-linked CDs

With so many moving parts, these CDs are an interesting investment product — one with several pros and cons.

Pros

  • Stock market exposure: Investors who want to participate in the market, but are afraid of the potential losses can get a taste of the opportunity. Your principal will not be at risk of the linked index or equity has negative performance.
  • Access to a variety of asset classes: CD investors can get exposure to potential gains from a wide variety of asset classes, like stocks, bonds, currencies and commodities.
  • FDIC insurance: Principal invested in a market-linked CD is insured up to the FDIC maximum of $250,000. However, the FDIC insurance does not cover speculative investments, so it does not insure any speculative market gains above and beyond your principal.

Cons

  • Underperforming returns: Market-linked CDs can underperform conventional CDs after deducting fees and caps. After analyzing the performance of 118 market-linked CDs, the Wall Street Journal discovered that only a quarter outperformed conventional five-year CDs, and about a quarter paid no return at all.
  • Higher taxes: Even though the CD is linked to the market, gains are returns are considered interest and not capital gains. While long-term capital gains have a 15% tax rate, interest on a market-linked CD is taxed at your income tax rate, which is likely to be higher than capital gains. In addition, you must declare interest each year, instead of at maturity, which means you must pay taxes before potential gains are realized.
  • Liquidity: These CDs are usually held for a term of five years. If you need the money, you will pay a high penalty for early withdrawal. It’s important to consider your liquidity and income needs before investing in a market-linked CD.

Should I invest in a market-linked CD?

Investors are often interested in market-linked CDs because of their potential to deliver higher returns than conventional CDs. While this is true if the market is performing well, a down market could tie up your money with little or no return.

However, if you want to take a chance on a higher return than a conventional CD, a market-linked CD might be worth the investment. “If you're a Nervous Nelly about the market and say, ‘Oh, I don't want to invest in the market because I could lose money,’ this is a good investment tool for you because it provides you with some exposure to the market, but not the downside exposure,” says Balcom.

What are my other CD options?

Conventional CDs and market-linked CDs are just two of your CD options. Another product is a jumbo CD, which requires an initial deposit of $100,000 and offers a higher rate of return than a conventional CD. A no-penalty CD allows you to access your money before the end of the term without penalty. A bump-up CD lets you switch your CD for one offering a higher rate if it comes available during your investment period. And a brokered CD is offered by a middleman, such as a stock broker or financial advisor who buys CDs in bulk from banks, negotiating higher rates.

The bottom line

Market-linked CDs offer the principal protection of a conventional CD with the potential of higher returns. Unfortunately, those returns aren’t guaranteed. Choosing this product comes down to your tolerance for risk, says Balcom.

“Anybody that wants a higher return than offered with bank CDs, this would be a better product for them,” says Balcom. “Somebody who says, ‘I'm worried about the market’ and ‘We're in near-all-time highs; I don't want to lose money,’– if they use those terms or phrases – it’s possible this is a good product for those individuals.”

The post Market-Linked CDs: What They Are and If They Are Right for You appeared first on MagnifyMoney.

Source: https://www.magnifymoney.com/blog/banking/market-linked-cd/

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