What Investors Need To Know About Market-Linked CDs

A CD that tracks the market may not be an investor’s dream

Tracking the stock market

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Most investors would love the idea of pursuing equity-like returns on their money without the risk of losing their principal if the markets go down. Market-linked certificates of deposit offer this potential.

With market-linked CDs, you can lock up your money for a certain term—five years is common—and receive interest payments based on the returns of an index, such as the S&P 500.

In theory, the idea of a market-linked CD seems sound. But there are many complexities to market-linked CDs that could impact how much you earn, and it’s important to read the fine print to determine whether they are the right kind of investment for you.

The Flexibility Trade-Off

With most CDs, you agree to keep your money in the account for a specified period of time in exchange for an interest rate that is typically higher than a regular savings account. If you withdraw money early, you are usually required to pay a penalty by returning all or a portion of the interest earned.

Market-linked CDs work in a similar fashion, but banks are often even less keen on you withdrawing money early.

“Investors typically will have limited opportunities, if any, to redeem their equity-linked CDs prior to maturity,” the SEC writes. “Moreover, the financial institutions do not guarantee the existence of a secondary market. Many equity-linked CDs do not permit the early withdrawal of your investment without the consent of the financial institution.”

If you have no intention of needing this money for a long time—such as until retirement—this lack of flexibility may not be a big deal to you. But it’s important to know that there could be a penalty for trying to access your money early.

It’s best to only use a market-linked CD if you are absolutely certain that you will not need the money before the date of maturity.

How Returns Are Calculated

Banks usually calculate the return on a market-linked CD by averaging the closing price of an index over a certain period of time. In many cases, they will match the CD to the S&P 500, which includes the largest public companies in the United States. One common way to calculate the return is to base it on the average closing price of the S&P 500 over the entire year, or a six-month period. Calculating returns this way might soften the blow if the market declines, but it may also reduce your return if the market rises.

A Cap on Upside

So you may think that if you invest in a market-linked CD, you’ll make a huge return if the market goes way up. Think again. Most market-linked CDs have a cap on the return an investor can earn. There are two calculations that come into play here:

  • The first is the participation rate. This is the percentage of an index’s return that will be used to determine the interest payment. For example, if the participation rate is 75% and the S&P 500 goes up 10%, an investor ends up with 7.5%.
  • Secondly, there are often hard caps on the total amount an investor can receive. If the cap is 12% and the market goes up 20%, the investor gets a max of 12%, regardless of the supposed participation rate.

Tax Implications

Like most CDs, income on market-linked CDs is often considered interest, not dividends or capital gains (though this can vary, so always check the CD disclosure statement on reporting interest income). This means the returns are taxed as regular income, just like income from your job. Usually, this income is taxed at a higher rate than qualified dividends or capital gains.

Depending on your tax bracket, you could pay significantly more to the Internal Revenue Service.

What’s more, income on market-linked CD’s is calculated annually, even if it is only paid when the CD matures. Imagine getting a bill for taxes on the money you have not even collected yet.

Investors can reduce or avoid these taxes by placing the CDs in an Individual Retirement Account (IRA). With a traditional IRA, taxes are deferred until you retire. With a Roth IRA, you pay no tax at the time you withdraw your money.

Beware of Call Features

The contracts for market-linked CDs often contain language allowing the bank to cancel the contract. Often, this cancellation kicks in when interest rates drop to a certain level, or the bank is given the option to call the CD in certain intervals (such as every six months). When this happens, the depositor gets her principal and accrued interest back without penalty but misses out on the potential for any future gains.

It is often in the best interest of banks to call back CDs when interest rates go down sharply. Fortunately, rates have been relatively flat this year, according to data from the FDIC, so the current risk of CDs being called is relatively small. But the risk is always there.

The Bottom Line

Ideally, market-linked CDs work best if you are able to invest your money for a long time. That’s because the stock market may lose money in the short term, but has been known to go up over the long term.

Unfortunately, most market-linked CDs don’t offer terms long enough to truly take advantage of gains over time. This makes them a less-than-ideal investment for most people. If you want to get some decent returns on your savings with minimal risk, you may be better off investing in high-yield bonds or dividend stocks.