A market-linked CD is a certificate of deposit with a return based on a collection of stocks or a market index, such as the S&P 500. One of these CDs can also be called an index-linked CD, an equity-linked CD, or an MLCD. With few exceptions, the principal amount in a market-linked CD is insured by the Federal Deposit Insurance Corporation (FDIC) up to a maximum of $250,000.
At first glance, it sounds like a good deal that offers diversification, market-based returns, and protection of principal. The deal seems even better when you consider the low rates paid by conventional CDs. The average traditional non-jumbo CD with a term of 60 months paid just 0.95% as of Feb. 3, 2020.
- A market-linked CD is a certificate of deposit with a return based on a collection of stocks or a market index, such as the S&P 500.
- These equity-linked CDs can be profitable, but many of them underperform traditional CDs.
- Market-linked CDs have numerous drawbacks, including fees if you cash out early, returns that are taxable as interest rather than as capital gains, and limits on gains.
Market-Linked CDs Often Underperform
Unfortunately, there are caveats. According to a Wall Street Journal analysis from September 2016, market-linked CDs often underperformed conventional CDs after fees, limits, and other factors were taken into account. The article analyzed 147 market-linked CDs issued since 2010 and discovered that 62% of them underperformed conventional CDs.
Furthermore, roughly a quarter of them paid no return at all. Although market-linked CDs can provide better returns than traditional CDs, you should only purchase them if you understand and account for their drawbacks. Below are six potential pitfalls.
Consider These Risks
1. Penalties for Early Cash Out
If you need to cash out your CD before it matures, you may end up paying a stiff penalty. The penalty could cancel out any interest earned. In some cases, it can even cause the loss of principal, according to the Securities and Exchange Commission (SEC).
2. Returns Taxable as Interest
Although your CD is linked to the market, returns on it are considered interest. You will likely have to pay income taxes instead of the much lower long-term capital gains taxes paid by stock investors. Furthermore, interest must be declared annually, even when it is only paid at maturity. That complicates owning a market-linked CD. Consider holding your market-linked CD in a tax-deferred account, such as an individual retirement account (IRA), to avoid paying those annual taxes.
If you buy a market-linked CD, diversify your assets and avoid high-risk investments. Take note of any fees, especially those that occur on the front end.
3. Capped Upside Potential
If the stock market rises substantially for the duration of your CD, you will not receive the full benefit of that increase. That's because market-linked CDs typically have a cap on returns. They might pay only a percentage of any increase in market prices or have a specific upper limit for gains. If the cap is a percentage of any price increase, it is called a "participation rate." If it is an upper limit for gains, it is called an "interest cap."
4. Call Risk
Some market-linked CDs have a call feature. This feature allows the issuing institution, typically a bank, to redeem the CD before it matures. Your interest rate is determined by the call price, and it might be less than it would be if the CD were held to maturity. The issuer is not obligated to call a market-linked CD.
Generally speaking, the investment will be called when it is to the advantage of the issuer to do so. If your investment is called, you may or may not be able to reinvest the proceeds at the same yield.
5. Lack of Dividends
There are typically no dividends with a market-linked CD. Dividend reinvestment is not usually an option like it would be with mutual funds. For some, the lack of dividend reinvestment is a significant downside. Other investors do not care and are more concerned with potential benefits, such as principal protection and guaranteed returns.
6. Stock Market Risk
Even when your market-linked CD has a guaranteed return, the net gain may be less than a conventional CD if the market goes down. Keep in mind that some market-linked CDs pay no guaranteed return at all. If you have only principal protection, you may be left with only your original investment and no interest when the market declines.