What Are Index-Linked Certificates of Deposit?

Index-Linked Certificates Of Deposit are financial instruments that combine the safety and protection of a traditional certificate of deposit (CD) with the potential returns of a major market average like the S&P 500 or Dow Jones Industrial Average. After Chase Manhattan Bank started offering these assets in 1987, many investment providers jumped on the trend and made them available to their clients. Investors are drawn to the index-linked CDs for the increased earnings potential and limited downside risk. In the United States, The Federal Deposit Insurance Corporation (FDIC) insures the principal of a CD up to $100,000. 

Understanding Index-Linked Certificates of Deposit

Index-Linked Certificates Of Deposit offer greater upside return than many other variations, but they are not necessarily any safer than a traditional certificate of deposit. Even though the initial investment can't be lost, there is a high possibility the index returns nothing. What's more, some providers will only match a specific percentage of the underlying asset's performance instead of the entire movement. It's a small tradeoff for investors, though. If a provider tenders 90% of the index's return in a bull market, it will likely exceed a CD yielding between 2 and 3 percent. When the index declines, some index-linked certificates return a guaranteed minimum investment where others only return the original investment. Investors looking for more certainty may want to consider a traditional CD. 

Risks of Index-Linked Certificates of Deposit

The opportunity to gain index returns with the safety and protect of a certificate of deposit looks great at first glance. Investors often learn, though, that unbelievable investments with low risks and high potential returns have a catch. Index-Linked certificates are no different. There are important caveats to consider before investing in a market-linked CD. In many cases, they tend to underperform a conventional CD after accounting for fees, taxes, and potential penalties. Cashing out a CD before it matures can result in a stiff penalty that eliminates any interest earned or in severe cases, a loss of principal. In addition, the performance of the CD depends on the current market conditions. That means a year-long downturn like 2015, which the S&P 500 recorded a 0.73% decline would result in lower returns than holding the funds in a savings account or traditional CD. Other factors to consider include tax liabilities, maturity dates, and opportunity costs. By locking down a CD for months or years, investors may be missing out on opportunities to generate greater returns in other asset classes.