Dedicated to Deposits: Deals, Data, and Discussion

Review of Market-Indexed CDs

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The Wall Street Journal has an article today that looks into market-indexed CDs. Here's how the article describes what a market index CD is:
Unlike traditional certificates of deposit, which earn a preset interest rate for a specific term, an indexed CD is linked to one or more financial indexes, such as the Standard & Poor's 500. If the market index to which your CD is tied rises in value, you capture at least a portion of that return. If the index falls, you still get your original deposit back. That deposit is also protected by the Federal Deposit Insurance Corp., up to standard limits.

Update 8/01/09: There's a useful post at WSJ's The Wallet blog at How To Shop for Market-Indexed CDs.

I've covered these CDs a few times during the last four years. My last post was in March when Compass Bank was offering this type of CD. I'm not sure if they're still offering it. EverBank has long offered several types of market-indexed CDs; however, its current MarketSafe CD is linked to foreign currencies instead of a stock market index. In the past EverBank's MarketSafe CDs were linked to the S&P 500 index.

As the WSJ describes, there are many potential downsides to market-indexed CDs. Some potential downsides as compared to stock mutual funds and/or regular CDs include (not all are mentioned in the WSJ article):
  • limits your upside compared to the market
  • substantial cost for early withdrawals (such as selling at a loss in the secondary market, a surrender charge or early-withdrawal penalty)
  • taxed as income not as capital gains (and the tax may be more than expected)
  • stock dividends not usually included in returns
  • tend to be very complex
Some of the above downsides are from other sources including this CNN article.

In my March post I described how one could build his own stock market CD by putting a portion of money into a regular 5-year CD and a portion into a stock mutual fund. Also in that post, readers provided some important potential issues to consider. Here is one comment from Andy:
If you consider an equity index CD, be sure and get really good details about how your interest is reported to the IRS each year. Some of these instruments have bad rules regarding this. I've seen some that report the 1099-INT as if you owned the STOCK for the year. You could find yourself paying a lot of income tax with no access to your money. It could be a very 'Anti-Roth' type investment.

Also, I'd triple check FDIC insurance charters if you buy one of these. Don't assume the bank you buy this from is the charter your insurance is under. These are often sold under the investment wings of banks and could be insured by another charter. Of course this is no problem unless you'd go over a limit.

Here's another potential downside described in the comments by OC Steve:
Another issue that I can remember from some years ago is...if...the bank fails, and the time period to determine the index change has not lapsed, the FDIC considers NO interest has been earned. This is the worst case I think with these type of index related CD's

If you have experience with these types of CDs or if you know of banks or credit unions offering these, please leave a comment.

Thanks to the reader Tuphat who mentioned this WSJ article in the Daily News & Deals Post.

Edit 8/01/09: Updates made to take into account critiques from the comments.

Related Posts

Comments
22 comments.
Comment #1 by Anonymous posted on
Anonymous
I have been doing business with FISN.com for years. However, I have always stayed away from the stock linked CD's. [None are listed today, but their offerings can change daily. Often they offer a stock-linked CD with a guaranteed interest rate for the term.] Right now I have a 7.00% rate linked to the LIBOR 6-month rate. The lowest interest that I have made with this company was 6.00%. That was when the interest rates were about 1.50% earlier in this decade. There is risk involved with some accounts, but only if you pick a non FIDC insured account. The accounts that I choose are FDIC insured. They have others that pay a much higher rate of return, but are not FDIC insured. I prefer to have my money insured.

On the downside. Some of the funds pay the interest into a money market fund paying only a 0.24% interest. The money market fund (Fidelity) is not FDIC insured, so there is a possibility that you can lose your interest if the company goes out of business.

Also on the downside is that the possible term of these CD's. Some are up to 20 years. I have had about 4 or 5 of these CD’s now and the maximum length before the bank called my CD was about 3 years. Most are called in the first two years.

The account I have is for my Roth IRA and I do not pay a yearly interest to the IRS for the earnings.

Also, before opening an account, I would do my homework. I think that the managers work on a commission and may not always recommend the best CD out there. I ask them to send me the past earning reports, graphs, etc. so that I can (hopefully) make a good choice. So far I have been quite happy with them. Earning a guaranteed 7.00% interest rate now in today’s financial environment puts a smile on my face.

Hope this helps.

1
Comment #2 by Anonymous posted on
Anonymous
.

>> So far I have been quite happy
>> with them.

Actually ... Me too.

The FDIC insurance is a strong motivating factor. That's why I've always bought CDs, rather than "Notes" offered by them.



>> Earning a guaranteed
>> 7.00% interest rate now in
>> today’s financial environment
>> puts a smile on my face.

Indeed ... Is that one of the non-callable CDs by Chase? I missed buying them.

Past two months I bought ones that are tied to CPI-U. They are non-callable. ... So if inflation rises and rises ... I'll get more and more ... if not ... well principal will be paid back anyways!



>> I have always stayed away
>> from the stock linked CD's.

In fact I like 'em. I always tend to buy a couple of them each month. US Titan 10 or World Titan 10. Something of those nature. Or some that are quarterly/yearly interest based. I tried "Absolute Return" with knock-out but the barrier got triggered for some of them due to volatility.



>> Also on the downside is that
>> the possible term of these
>> CD's. Some are up to 20 years.
>> I have had about 4 or 5 of
>> these CD’s now and the maximum
>> length before the bank called
>> my CD was about 3 years. Most
>> are called in the first two
>> years.

... I was tempted by the Yield Steepner ones recenly. But the call feature put me off. It is almost like the banks will call if/when the rates gets too high for them to pay.

.

1
Comment #3 by Anonymous posted on
Anonymous
.


>> If you have experience with these
>> types of CDs or if you know of
>> banks or credit unions offering
>> these, please leave a comment.

Well ... I got a whole lot of experience with them. Several banks offer them. Barclays Bank, UBS Bank, Wells Fargo Bank, Citi Bank, HSBC Bank, Chase Bank, Harris N.A., SunTrust Bank to name a few ... and of course they are with good-old FDIC insurance. Oh ... and my non-financial advice will be to get the preliminary prospectus of the CDs prior to buying and going over it thoroughly with your financial adviser, your tax adviser (err ... maybe even your shrink!) to check its suitability for yourself.


.

1
Comment #4 by Anonymous posted on
Anonymous
.


>> As the WSJ describes, there are
>> many potential downsides to
>>> market-indexed CDs. These
>> include:
>> * limits your upside compared
>> to the market
>> * severe early withdrawal
>> penalties


... No ... there is no such thing as an early withdrawal penalty for these products.

There is a death-put (or adjudication of incompetence) at par for the owner(s), but other than that if you need to withdraw early ( in financial terms it is called as selling or redeeming the CD) then you got to find a buyer for your CD, in a nearly non-existent secondary market.


.

1
Comment #5 by Anonymous posted on
Anonymous
Stock-linked CD are actually bonds disguised as CD. Furthermore, you are a just a part owner of the group CD.
There are lots of hidden fees, the yield is not what is advertised and there are more risks involved.
Since, there is nothing certain about these CDs. I never got involved and I think they are not for me.

1
Comment #6 by Anonymous posted on
Anonymous
.


>> Since, there is nothing
>> certain
about these CDs.

... Not quite ... The FDIC insurance for the principal is completely certain.



>> There are lots of hidden fees,

Really? ... Point out some of them, that are not disclosed in the preliminary and final prospectus.


.

1
Comment #7 by Anonymous posted on
Anonymous
>>> Earning a guaranteed
>>> 7.00% interest rate now in
>>> today’s financial environment
>>> puts a smile on my face.

>>Indeed ... Is that one of the
>>non-callable CDs by Chase? I
>>missed buying them.

Yes, that one was from Chase. Three days after I bought it the rate went up to 7.25%. Oh well, you can win all the time.

1
Comment #8 by Anonymous posted on
Anonymous
Banking Guy,

WSJ has not described any early withdrawal penalties at all. You better read the article carefully.

Moreover it is too obvious that CD generates "income". There is nothing like a "capital gain" for a CD. So what's the issue if the tax you got to pay is on the "income"?

When was the last time that you paid "capital gain" taxes on the whole bunch of CDs you keep blogging about?



Anonymous of 12:31 PM, July 30, 2009,

You are right. There is nothing like "early withdrawal penalty".

1
Comment #9 by Anonymous posted on
Anonymous
.


>> As the WSJ describes, there are
>> many potential downsides to
>> market-indexed CDs. These include:
>>
>>         * tend to be very complex


Sure ... If your skills are, shall we say limited, to counting every month the number of debit card transactions you performed for your reward checking account and fussing over whether you did 9 or did you complete 10 (hooray), then I see that these market linked CDs may be very complex for you to comprehend, as the Wall Street Journal may have suggested.


.

1
Comment #10 by Ari Weinberg (anonymous) posted on
Ari Weinberg
Structured products, be they index-linked CDs or index-linked stocks or otherwise, are always a better deal for the institution than the buyer. Why not consider a traditional CD and a LEAP?

1
Comment #11 by Banking Guy (anonymous) posted on
Banking Guy
Note, the list of downsides are not directly from the article. Regarding the early withdrawal penalty, perhaps another term would be better since most market-indexed CDs are like brokered CDs. You can still be penalized in a sense for early redemption. From the article:

"So Mr. Palumbo cashed out his indexed CD in January to seek out other investments. He ended up recouping 92 cents on the dollar."

Also, here's EverBank's disclosure for their MarketSafe CD:

"If you do withdraw early, even if that is due to the death or adjudicated incompetency of the holder of the CD, you will NOT receive Principal Protection and will NOT benefit from any upside potential of the Reference Index, experiencing a loss of principal as an early withdrawal charge."

Regarding the tax issue, this downside is when the market-indexed CD is compared to stock mutual funds. It's similar to the first downside in that it limits your upside as compared to the market.

1
Comment #12 by Anonymous posted on
Anonymous
.


>> Note, the list of downsides
>> are not directly from the article.

Exactly ... That's what I thought. So these downsides are not what the WSJ author has written. It is your attempt at interpreting the article.



>> Regarding the early
>> withdrawal penalty, perhaps
>> another term would be better

Right ...

In my experience most of the WSJ articles are well written, and they use accurate terms.



>> Regarding the tax issue, this
>> downside is when the market-
>> indexed CD is compared to stock
>> mutual funds.

Well ... then don't compare!

If you compare one type of CD to another then maybe you are not stretching it. A "bump-up" CD, compared to "fixed-rate" CD, compared to "market-linked" CD, perhaps is apples-to-apples.

When you start a CD comparison to a Mutual Fund, then I'd say you are doing apples-to-oranges comparison, and you are stretching it. Oh ... and if this sort-of stretched comparison is really forced, then how about stating the most obvious upside of the "market-linked" CD compared to a Mutual Fund? A Mutual Fund, in theory, can lose all of its principal, but the "marked-linked" CD has a huge advantage that its principal is FDIC insured (within the limit stated by the law), so the value of the principal (within FDIC limit) cannot decrease!


.

1
Comment #13 by Anonymous posted on
Anonymous
I see that Banking Guy has an admirer.

1
Comment #14 by Anonymous posted on
Anonymous
Banking Guy,

Downsides you have interpreted off the article are ridiculous. You slipped & fell flat on your face.


Anonymous,

I think Banking Guy is catering to his mostly simple audience. To them either the market linked CDs are really to hard to understand or they are "sour grapes" products are just beyond their reach. So Banking Guy was simply trying to talk down these market linked CDs.

Glad to see you have stepped in to set Banking Guy honest.

1
Comment #15 by Anonymous posted on
Anonymous
To Anonymous, at 10:24 AM, July 31, 2009.

Yes, the principle is at risk. FDIC does not cover all fees and penalties for early withdrawals, which can amount for a substantial loss. Also, if a fraud is suspected in any stage of the issuing the CD or a rogue employee makes a mischief with your money, guess what, FDIC will wash the hands from you and your money.
It is obvious, you have not thought about that possibility and defending the index CD is not a right thing to do.
There are much more risks than a plain vanilla CDs, whether you admit to it or not is irrelevant, but that is the truth.

1
Comment #16 by Anonymous posted on
Anonymous
Comment Policy
Constructive criticism is welcome, as we all benefit from such advice. Rude, mean, or obnoxious comments are not welcome and may be removed. Comments with offensive language, spam or comments that infringe on copyright material are also not permitted and may be removed.

You agree that comments may be removed if there are allegations of defamation.

1
Comment #17 by Anonymous posted on
Anonymous
.


>> Banking Guy,
>>
>> Downsides you have interpreted
>> off the article are ridiculous.
>> You slipped & fell flat on your
>> face.

Indeed ... I got the same feeling!



>> Anonymous,
>>
>> I think Banking Guy is catering
>> to his mostly simple audience.
>> To them either the market
>> linked CDs are really to hard
>> to understand or they are "sour
>> grapes" products are just
>> beyond their reach.

Sure ... I imagine so. It is rather hard to judge the intelligence/skills/grasp-of-subject-matter a writer/reader has. Therefore for the non-savvy writers/readers who are sort-of limited in their abilities, understanding/evaluating/comparing the merits of 'fixed-rate' CDs vs 'market-linked' CDs perhaps is too much to expect.

There surely is a possibility that the people are finding faults with the product that is beyond their reach. ... Yes ... this could be "sour-grapes" syndrome ;-)



>> So Banking Guy was simply
>> trying to talk down these
>> market linked CDs.

Well ... then there is a possibility that Banking Guy was really interested in these products, was really trying to understand these products, was not just trying to talk it down. Rather than drawing a bad conclusion unilaterally about someone's intentions give him/her the benefit that maybe his/her intent was good. Just that the attempt to draw conclusions failed.


>> Glad to see you have stepped in
>> to set Banking Guy honest.

Actually it is not as if I wanted to "set Banking Guy honest". It is more like I got a feeling that the downsides pointed out are of little or no merit at all.


.

1
Comment #18 by Anonymous posted on
Anonymous
I recently purchased a Bank of America Indexed CD that is linked to the S&P 500. It seems that the CD immediately lost about 2% of its value.
I purchased the CD when the S&P was at 895.1. Today it is at 1010.36. The value of the CD does not show this gain and still reflects a 2% loss.
Am I missing something here ?

2
Comment #21 by Anonymous posted on
Anonymous
a market linked CD we purchased almost 4 years ago when the S&P was at 970 has proved to be a real disappointment to us.  We accepted the bank financial advisor's description of the instrument as being limited to 30% return over 4 years, and had no concept of the OID business, paying tax on money not yet received....AND, to top it off, read the terms sheet closely to discover that not only were we limited to 30%, if the S&P increase exceeded 30%, we were penalized and only given 20%!!!   What a lousy deal that is!

 

The bank responded by saying that the devices they offered from Regions Bank changed every month and that we should have been more cautious about our decision if we weren't prepared to understand all the terms.

 

In other words, "You signed the paper, not shut up and go away!"

1
Comment #22 by Anonymous posted on
Anonymous
I must correct something in the previous post.  For some reason I sincerely thought the instrument sold to us by Compass (BBVA) originated from Regions Bank out of Birmingham.  that does not seem to be correct.  The CD is, apparently, totally devised by and sold by Compass financial advisors.  I've already apologized to Regions, a bank I am sure would never **** a customer the way BBVA did.

1