Market-linked CDs, also known as index-linked CDs or equity-linked CDs, refer to certificates of deposit with a return based on a market index (such as the S&P 500), a basket of equities or some combination of both. With few exceptions, the principal amount in your market-linked CDs 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 offering diversification, market-based returns and protection of principal. With the average non-jumbo traditional five-year CD paying just 1.53%, according to the FDIC, the deal sounds even better. (For more, see Index-Linked Certificates of Deposit: Upside Potential, Low Risk.)

Market-Linked CDs Often Underperform

Unfortunately, there are caveats. According to the Wall Street Journal, after fees, limits and other factors come into play, market-linked CDs often underperform conventional CDs. The newspaper analyzed 147 market-linked CDs issued since 2010 and discovered that 62% of those products 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 consider such a product if you fully understand and account for the potential downside. Here are six potential pitfalls.

Watch for 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 and in some cases even cause a loss of principal, according to the Securities and Exchange Commission (SEC).

2. Returns Taxable as Interest

Even though your CD is linked to the market, returns on it are considered interest, not capital gains. Therefore your tax rate will likely be much higher than the 15% you would pay on long-term capital gains. Furthermore, interest must be declared annually, even when it is only paid at maturity. This complicates owning a market-linked CD. Consider holding your market-linked CD in a tax-deferred account, such as an IRA, to avoid paying those annual taxes.

3. Upside Potential Capped

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 return. The cap can be in the form of a percentage of any increase or up to a specified cap limit. If the cap is a percentage of any increase, it is called a “participation rate.” If it is a limit on percent of return, it is called an “interest cap.”

4. Call Risk

Some market-linked CDs have a call feature. This allows the issuing institution (typically a bank) to redeem the CD before it matures. Your interest 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. (For more, see Callable CDs: Check the Fine Print.)

5. Lack of Dividends

There are typically no dividends with a market-linked CD, so dividend reinvestment is unlikely an option as it would be with regular stocks, mutual funds or other types of investments. For some people, the lack of dividend reinvestment is a significant downside. For others, it is less important given the principal protection and, in many cases, guaranteed return.

6. Depressed Market Hurts Returns

In the event your market-linked CD does have a guaranteed return and the market goes down, the net return may be less than you'd have received from a conventional CD. Keep in mind that some market-linked CDs pay no guaranteed return at all. If you are invested in such a CD and the market is depressed during the term of your investment, you may actually receive no return at all – leaving you only with your original principal.

The Bottom Line

The main advantage of a market-linked CD is exposure to the stock market without the risk of losing your initial principal. As has been noted, however, even principal can be at risk under certain circumstances. If you buy a market-linked CD, it’s advisable to diversify your assets and to avoid high-risk investments. You should also take note of any fees, especially those that occur on the front end. As with all important financial decisions, meet with a trusted financial adviser to discuss the appropriateness of this product for you.