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Index-linked certificates of deposit, also known as equity-linked certificates of deposit, provide the opportunity to generate investment returns that are similar to those provided by well-known major market indexes, such as the Standard & Poor's 500 Index (S&P 500) the Dow Jones Industrial Average (DJIA) or Nasdaq, with the safety and security of the principal protection provided by traditional certificates of deposit (CD). Chase Manhattan Bank was the first firm to offer index-linked certificates of deposit, which debuted in 1987 and were quickly made available by many other investment providers. In this article, we'll explain the benefits of these investments and why you may want to consider them for your portfolio.
Appeal
Index-linked certificates of deposit have a strong appeal to investors who want to earn stock-market like returns on their investments but don't want to risk the loss of principal associated with investing in the stock market. To meet this need, index-linked certificates of deposit link the returns that investors will earn to the returns generated by one of many major equity market indexes. Some offer to match 100% of the return generated by a given index. Others match a specific percentage, such as 90%. If the index declines, some index-linked certificates offer a guaranteed minimum investment return, while others guarantee only the return of the original investment. In the U.S. the Federal Deposit Insurance Corporation guarantees the principal up to $100,000. (To learn more, read Are Your Bank Deposits Insured?)
Considerations
While index-linked certificates of deposit guarantee no loss of principal when held to maturity, there are other factors that should be taken into consideration prior to investing. For example, access to principal and earnings is often limited. The specific terms of the investment vary by provider, with some providers issuing certificates for three years, five years or another set period of time. Some certificates do not permit access until the certificate has reached maturity. Others provide a window, such as once per year, when the assets can be withdrawn penalty free. If access to the money is required at any other time, a penalty may be imposed.Also, if the chosen index declines in value, the return on investment may be as low as zero. This raises the issue of opportunity cost, because the money might have generated positive returns had it been invested elsewhere.Tax implications are another item that should be taken into account, as earnings generated by index-linked certificates of deposit are taxed in the year generated. To delay tax liability, the certificate can be purchased in a tax-deferred account, such as an individual retirement account (IRA).
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