Certificates Of Deposit: Bells And Whistles (Part 2)
The list of features that CDs offer is long and impressive. We explored a number of the varieties in Certificates Of Deposit: Bells And Whistles (Part 1) and will review some additional complex and interesting variations below.
Index-linked CDs, also known as market-linked or equity-linked CDs, 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 security of the principal protection provided by traditional CDs.
Index-linked CDs strongly appeal to investors who want to earn 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 CDs link the returns that investors earn to the returns generated by one of the 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 CDs offer a guaranteed minimum return, while others guarantee only the return of the original investment.
Keep in mind that 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 issue to consider because earnings generated by index-linked CDs are taxed in the year generated. To delay tax liability, the certificate can be purchased in a tax-deferred account, such as an IRA (IRA).
Jumbo CDs, sometimes referred to as negotiable CDs, require a minimum investment of $100,000. They typically pay higher rates of interest than other CDs and are often bought and sold by large institutional investors, such as banks and pension funds. They are referred to as "negotiable" because they can usually be sold in a highly liquid secondary market, but they cannot be cashed in before maturity.
Liquid CDs permit investors to withdraw money from their accounts without incurring any penalties. Terms and conditions vary widely according to the issuer. To remove money without paying a penalty, the investor may need to maintain a minimum account balance. Also, the bank may pay a lower rate of interest than a traditional CD, to provide the investor with the ability to take money out of the account. The number of permitted withdrawals varies by provider.
Uninsured CDs are not insured by the Federal Deposit Insurance Corporation (FDIC), which insures many certificates of deposit for individual accounts, or by the National Credit Union Administration (NCUA), which covers many credit union deposits. In some cases, CD amounts are uninsured because they exceed the insurance coverage limit.
In other cases, uninsured CDs are purchased by investors seeking a higher rate of interest than the rate available through insured CDs. Because the safety of insurance is one of the most attractive features CDs offer, conservative investors often avoid purchasing uninsured products or opening CDs in a single financial institution above the insurance-coverage limit.
Some variable-rate CDs pay an interest rate that moves up and down based on the changes in an underlying interest-rate index. These CDs stand in contrast to traditional CDs, which pay a fixed rate of interest. Variable-rate CDs offer an opportunity to earn a higher interest rate when the underlying index moves in the right direction (upward), but can also result in earning an interest rate that is lower than the rate offered by fixed-rate CDs if the underlying index moves in the wrong direction (downward).
Yankee CDs are negotiable CDs issued in the U.S. by foreign banks. They generally have investment minimums of $100,000 and appeal primarily to institutional investors.
Zero-coupon CDs do not pay interest, but are traded at a deep discount, rendering a profit at maturity when the CD is redeemed for its full face value (or worth). For example, it may be possible to purchase a $100,000 zero-coupon CD for half price: $50,000. After holding the CD for a term of 10 years, it could be cashed in for its face value of $100,000. The tradeoff is that phantom interest accrues each year, and the investor must pay taxes on it, despite not actually receiving any money. Holding a zero-coupon CD in a tax-deferred account provides a way to postpone paying the taxes.
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