Market Linked CD – Is it the right choice?

7 Jun

Here is a question that is on the mind of many investors these days: ” How about market linked CDs? I would like to stay away from the equities market but somehow still benefit from any potential upside in securities while getting FDIC protection. Are equity linked CDs the right choice for me?”

The most appropriate answer really is: “It depends…”

Below, I will explain the advantages and disadvantages of market linked CDs and in which circumstances we at The Baron Group, LLC usually recommend investing in market-linked CDs.

Market-linked CDs (also referred to as market-indexed or equity-linked CDs) are certificates of deposit based on one or more asset classes such as securities or market indices. By purchasing a market-linked CD the investor participates in the growth of the underlying security or index while preserving the characteristics of a traditional CD, Including protection against market decline. When market-linked CD is held to maturity its principal is protected and the investor receives interest based on the performance of the underlying asset class during the term of the CD or on redemption date. In other words, they combine the upside potential of the equity market while providing the traditional security of a bank CD. The best of both worlds! Especially in the current tumultuous economic environment of very low interest rates and volatile stock market returns.

Here are a few specific benefits:

Protected Growth

Market linked CDs provide the potential for capital appreciation based on the performance of an underlying asset or basket of assets with complete protection of the original deposit, when held to maturity. So basically, the value can go up with the market but cannot go down. It is important to remember that if the market-linked CD issued by an FDIC insured Bank (those are the only ones I recommend anyways), the FDIC insures the original deposit if the issuing bank becomes insolvent.

Performance

Market Linked CDs have the potential to earn greater returns than traditional fixed income instruments over the same duration. This performance is generated by the assets the CD is linked to and the payoff structure used. Market Linked CDs can be designed for growth strategies, income strategies or a combination of both.

Diversification

Diversification is achieved through these main characteristics:

Asset Class: Market linked CDs can be linked to a wide variety of underlying asset classes such as equities, commodities, currencies, market indices, fixed income, inflation and more.

Geography: Exposure can be achieved to foreign and emerging markets without the additional currency risks of direct equity investment.

Customization: Market Linked CDs can be structured with various levels of complexity to accommodate specific investment needs that could be difficult to replicate by independent investors.

With the above benefits is mind, we need to also consider the risks of MLCDs.

Liquidity

If the CD is redeemed prior to maturity, the principal will not be protected and the investor may realize a loss, even if the underlying asset has appreciated.

Therefore, I always recommend purchasing market-linked CDs only if the intent is to hold these CDs to maturity.

Performance/Market Risk

The performance of Market Linked CDs is based on the performance of the underlying asset(s) with respect to the type of payoff structure. Generally, a Market Linked CD’s – possessive performance may be less than investing directly in the same underlying asset(s). Clients are at risk of underperforming a traditional fixed income instrument if the asset(s) used to determine the performance of the MLCD devalue over the life of the CD.

Tax Considerations

Just like any certificate of deposit, market linked CDs’ returns are considered interest for tax purposes, therefore the tax rate may be higher than the capital gains rate. However, the investor typically does not have tax liabilities if the market linked CD is purchased in a qualified account like an IRA.

So, back to the original question – is a market-linked CD the right choice for me?

While anyone can invest in MLCDs and they are an excellent compliment to any well-balanced portfolio, there are a few specific types of investors who may benefit from market linked CDs the most. Generally speaking if you are retired, a baby boomer, a family who would not want to see their children’s college fund diminish in value, or if you are any conservative, risk averse investor, then a market linked CD may be the right option for you.

However, just like with any other investment decision, your individual overall investment goals need to be evaluated in order to determine the most effective investment strategy. Although certain general rules apply, there is never a “one size fits all” answer when it comes to investing. Your adviser will help you determine the most favorable strategy in your particular case, shop around for the best combination of rates, minimum deposit requirements, maturity dates, and early withdrawal provisions. With a carefully designed investment strategy, tailored to your individual tolerance for risk, you are best equipped to reach your financial goals.

Best of luck!!

3 Responses to “Market Linked CD – Is it the right choice?”

  1. smbrisard June 12, 2012 at 9:23 pm #

    Great article Timothy Mobley – well written and addressing important matters!

    • timothymobley June 14, 2012 at 1:16 am #

      Thank you for visiting my blog!

    • timothymobley July 25, 2012 at 11:42 pm #

      Thanks! Market Linked CDs are a good option for risk averse investors.

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