It wasn’t so long ago that certificates of deposit (CDs) enjoyed a special place in the hearts of savers everywhere. But, CDs were looked down upon by investors who pinned their hopes on generating above average rates of return investing in the stock market. As market volatility took its toll on active investor’s portfolios, a new hybrid investment was created to address the needs of conservative savers. The new offering, called an equity-linked CD, guaranteed return of principal and payment of interest if the market index did well. The best part is that it’s covered by the FDIC program.
Also known as a market-linked CD or the indexed CD, they all follow the same basic premise: offer a time-based deposit vehicle (CD) and link its interest payments to a group of securities or an index. Add a few restrictions regarding how much of the index gain the investor will participate in, put a cap on the amount the investor can realize on an annual basis and make the CDs callable, like a bond. One more feature (for the issuer that is) create two methods to calculate the interest to be paid. Additional information and guidance is provided by the Securities and Exchange Commission (SEC).
Most equity-linked CDs are tied to an index like the S&P 500 or the NASDAQ. This enables CD investors to participate in some of the gain of an improving market. All equity-linked CDs have a participation rate that limits the amount of the index performance that will be used in the calculation of gain. For example, a five year equity-linked CD indexed to the S&P 500 may limit participation to 70 percent of the total gain of the S&P 500. So if the index increases 15 percent the first year and the participation rate is 70, the rate to be paid to the investor would be 10.5 percent. This calculated rate may in turn be subject to a cap which limits the annual interest paid or the lifetime interest. If an equity-linked CD has an annual cap of 9 percent then in this example, instead of being paid 10.5 percent, the investor would receive 9 percent as provided by the limit.
A feature that should be avoided is the callable option whereby the issuer of the CD may call or purchase the CD at face value plus accrued interest. Most banks would buy back an equity-linked CD in a strong economy because despite the participation rate limiting the amount of gain in an equity-linked CD, a well-performing index could drive interest up to the cap limit for several years to come. Taxes may also be different with an equity-linked CD. Because unlike direct investments in equity securities, where you may pay less tax for capital gains or dividends, the interest paid on an equity-linked CD could be taxed as high as 35 percent. Liquidity is concern if in an emergency you need access to your funds. While you won’t lose your principal, you may lose some or all of the interest payable on your CD in the event of early withdrawal.
One last consideration is how to calculate the rate of return. Two methods exist, 1) point to point or 2) averaging. Point to point simply takes the index value date the CD was purchased and compares it to the index value one year later. The difference is the rate payable, subject to the participation rate and cap limit. The averaging method uses six month time periods to establish the performance figure. This usually benefits the issuer, because an average tends to smooth out performance returns that occur near the end of the term.
Clearly an equity-linked CD is more complex than a traditional CD, but it can offer security of your principal and a potentially higher rate of interest. It may also yield no interest if the index declines over the term of the CD. Make sure you understand the restrictions and penalties that apply before you invest in an equity-linked CD.
Banks offering Equity-Linked Certificates of Deposit: