Index-Linked Certificates Of Deposit: Upside Potential, Low Risk

By Lisa Smith AAA

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 Others provide a window, such as once per year, when the assets can be withdrawn penalty free.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).

Strategies
Index-linked certificates of deposit can be used in a variety of ways. They can provide safe storage for money that you do not expect to need for several years. They can also be used as the more conservative end of a larger portfolio's asset allocation strategy. (To learn more about how choosing the right mix of securities is the key to minimizing risk while maximizing return, read Achieving Optimal Asset Allocation and Asset Allocation Strategies.)

Index-linked certificates can also be used as part of a laddered fixed-income strategy. Fixed income investing often takes a backseat in our thoughts to the fast-paced stock market, with its daily action and promises of superior returns, but if you're a retired investor, or are approaching retirement, fixed-income investing can become your primary focus. At this stage, preservation of capital with a guaranteed income stream becomes the most important goal. Using index-linked securities has the potential to boost the returns of a laddered portfolio. (For additional insight into this strategy, read Step Up Your Income With A CD Ladder.)

Read Before You Buy
Index-linked certificates of deposit are available from a variety of providers, although they are not often touted by brokers because they are not a major revenue generator in terms of sales commissions or fees for selling them. Because they come in a range of terms with widely varying underlying provisions, careful shopping will help you identify the exact offering that best meets your personal investing goals.

Bottom Line
In every case, index-linked certificates of deposit are best suited to investors who do not need immediate access to their money. Prior to investing, it is important to be sure that you understand all of the terms and conditions, particularly those related to the index that your investment will be tracking, the percentage of the index's return that will accrue to your account, the amount you will earn if the underlying index declines in value, the accessibility of your principal and the penalty for early withdrawal. Paying attention to these details before you invest will go a long way toward making sure you are satisfied with your investment tomorrow.

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