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Banking 101: What Is a Market-Linked CD?

Written by Jolene Latimer | Published on 9/23/2019

Note: This article is part of our Basic Banking series, designed to provide new savers with the key skills to save smarter.

For the cautious investor, market-linked CDs present an opportunity to potentially participate in the upside of market growth without taking on large amounts of risk. That’s because a CD, short for a certificate of deposit, is a federally insured savings account. It grows over a set period of time, generally at a fixed interest rate.

With a market-linked CD, the interest rate fluctuates with the market, giving the owner of the CD the potential to earn more interest than at a fixed rate. However, this type of CD does have its drawbacks. There are tax considerations, and the bank could call back the investment at any time, potentially wiping out the potential upside.

Here’s how to decide if a market-linked CD is right for you.

In this article we will cover:

What is a market-linked CD?

A market-linked CD is a certificate of deposit that’s based on a market index, such as the S&P 500 or a basket of stocks, or sometimes a combination of the two. Sometimes you might see the terms indexed CD or equity-linked CD used interchangeably with market-linked CD. All of these terms refer to the same product.

What being market-linked means is instead of earning a fixed interest rate, the investment will earn interest based on what’s happening in the market. Like a traditional CD, a market-linked CD will still have a set term. However, generally speaking, market-linked CDs have longer terms than a traditional CD. It’s common for market-linked CDs to last for years, with the typical term being five years, while a traditional CD’s term can be shorter, from a few months to a year or longer.

Because the performance of this type of CD is dependent on what’s happening in the economy, there’s a chance its growth could outpace that of a traditional CD, if the market is doing well. However, if the market takes a turn for the worst, so does the market-linked CD. The principal and any guaranteed interest on it is, however, insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000.

How market-linked CDs compare to traditional CDs

If you’re looking into investing in a CD, you’ve probably debated between market-linked versus traditional CDs. Don’t assume the rules are the same for both versions of a CD. Even though they sound similar, there are some key distinctions that could play a huge role in your decision between one or the other. Here are the key differences:

  • Interest rate: Market-linked CDs have a variable interest rate that fluctuates based on market factors, while traditional CDs have a fixed interest rate.
  • Participation rate: When it comes to this type of CD, your earnings are determined by your participation rate within the linked index. If you have a participation rate of 80% and the market rises 10%, you’ll see an 8% gain in your CD, though many of these CDs have a cap on return. Traditional CDs don’t have these considerations and instead merely grow at the set interest rate.
  • Payment: Earnings from a traditional CD are paid periodically, while earnings from a market-linked CD are paid at the end of the term.

The risks of market-linked CDs

Even though these CDs might sound appealing to some investors, here’s what you should watch out for if you’re considering one.

Early withdrawal penalties and other fees

These CDs do have associated fees and penalties. Since you’re signing up for a set term, if you withdraw your funds early you could pay an early withdrawal penalty. You’ll have to check the terms of your CD before signing to review what this penalty would be in your individual circumstance.

Additionally, these CDs could have a distribution fee or broker’s fees associated with them. For example, Fidelity lists placement fees, structuring and development fees as costs of a market-linked CD. Investors should review each offering carefully before moving forward.

Capped returns

Some of these CDs have a maximum amount that you can earn per year, no matter how well your index performs. This is calculated in addition to your participation rate, which can make understanding your earnings somewhat complicated.

For example, let’s say your index goes up 20% and you have a participation rate of 60%. If you have a capped return at 10%, instead of getting 60% of 20% (which would equal a 12% return), you’ll get a 10% return because that’s what you’re capped at.

Tax treatment

Market-linked CDs are taxed the same as conventional CDs. Interest earnings from both are taxed as regular income, and taxes must be paid annually.

“The ordinary income tax has to be declared annually even though you’re not getting interest until maturity. You’re paying income tax on money you haven’t received yet,” said Maggie Johndrow, a financial advisor and partner at Johndrow Wealth Management.

This could make the CD financially untenable for some investors, which is why Johndrow recommends linking a market-linked CD to a tax-deferred account, such as an IRA.

Call features

A feature that makes the potential upside of these CDs less secure is that they’re callable. This means that the bank can redeem the CD before maturity at any time it wishes. There’s a set call price, which determines how much you’ll earn if your bank calls your CD.

“Typically, institutions call CDs back when it’s favorable for them and not the investor. The bank is essentially predicting that if they let the CD go to maturity, they’ll have to pay more instead of calling now,” Johndrew said.

This can be frustrating for investors who expected their market-linked CD to outperform a traditional CD. “Sometimes the call price might be even less than the interest rate you would have gotten on a traditional CD,” said Johndrow.

The benefits of market-linked CDs

Even though these CDs have some risks, there are upsides to investing in them. Here are the benefits some investors may see in market-linked CDs.

Stock market exposure

When you contrast a market-linked CD to a traditional CD, one of the benefits is that you do have the opportunity to participate in the market instead of being locked into one interest rate. “The risk you get into [with a traditional CD] is inflationary risk,” Johndrow said. “If the guaranteed interest rate is low and interest rate and inflation are higher, then your money isn’t outpacing inflation.”

A market-linked CD is still insured and gives you the opportunity to possibly earn a bit more if the market grows, so you mitigate the risk of inflation outpacing your investment long term. However, remember that with this potential upside also comes the risk that the market will slow and you won’t see any growth on your investment.

Potential for higher returns

With a traditional CD, you have no potential to get a higher return than your fixed interest rate. When it comes to the market-linked CD, the potential is theoretically there because you get to participate in the market.

That potential is somewhat mitigated by the capped returns, participation rate and the potential for a bank to call the investment though. Plus, if the market stalls or dips, you could end up not seeing any growth on your investment.

FDIC insurance

A market-linked CD is FDIC-insured up to $250,000, which can be meaningful if you take a very conservative approach to your investments. If there’s a run on the banks, the federal government has guaranteed that you’ll get back up to $250,000 of your principal and any guaranteed interest.

How to calculate return on market-linked CDs

There are two different ways to calculate your return on a market-linked CD:

  • Point-to-point method: With this method, you’ll directly compare two values: the value of the CD on date of issue and the value right before its maturity date. The percentage of the difference between these two numbers is the return on your CD.
  • Average method: You can also calculate the return by pulling several data points on the value of the index at predetermined points throughout the life of the CD. Average these values to find the return of the CD in real time.

Don’t forget to calculate participation rates and interest rate caps into your return. It’s not enough just to look at how the index is doing throughout the lifetime of your CD; you also need to consider that in relation to your participation rate in that index. You will get a percentage of the growth of the index, but possibly not 100%.

If the stock market dips throughout the life of your CD, it’s possible that you won’t receive a return at all.

Are market-linked CDs a good investment?

Not every investor will be drawn to this type of CD, but for some people it’s the right choice. Johndrow thinks that type of person is “somebody who wants to participate in the upside in the market, and is OK not having the full upside, but is very nervous about the downside.” Basically, she said, they’re best for “a person who doesn’t want to lose a single dollar in the downside.”

Because the funds in this CD are tied up until maturity, investors who want more liquidity in their investments might consider other options. “If you want a guaranteed interest rate you might be better with a high-yield savings account or traditional CD that maybe isn’t tied up for very long — maybe a few months or a year,” Johndrow said.

  |     |   Comment #1
This is in contrast to earnings from a traditional CD, which are taxed as capital gains.

Are you sure about that? I thought CDs like Savings accounts are taxed as income since they're guaranteed.
  |     |   Comment #2
Earnings from a CD are reported as interest on form 1099-Int. Doesn't matter whether it's a term rate CD or the rate is market linked. This is a pretty serious gaffe by the writer. Wonder how the writers on DA are being vetted.
Ken Tumin
  |     |   Comment #3
Thanks for pointing out the errors in the article on how CDs are taxed. The article has been updated with these corrections.
  |     |   Comment #4
Interest in market linked CDs are taxed as an OID and it assumes you made that x% that year and it’s possible at end of the term you may have made less or nothing. It adds to your cost basis and it turns out to be a loss on the year it matures assuming less interest is paid than OID
  |     |   Comment #5
Does anyone knows where we can explore and find more of market linked CD offerings. I have couple Do options but nothing exhaustive ..
  |     |   Comment #6
Yes - Fidelity offers them in monthly batches, usually posted mid-month and issued at month end. If you have an account with Fidelity, you can use the following link:

  |     |   Comment #7
Unfortunately, most of the articles out there are similar in nature to this one - particularly focusing on the drawbacks of market-linked CDs instead of the benefits.

Personally, I've been regularly purchasing market-linked CDs monthly from Fidelity over the past 2 years and love them. The ones I own have been performing wonderfully, as the equity markets have been doing well.

I see the big benefit is that the investor gets market exposure with none of the downside risk. All of the market-linked CDs offered (at least through Fidelity):
1. Are FDIC insured

2. Are guaranteed not to lose principal when held to maturity

In the current interest rate environment, I do not believe the point highlighted in the article that you may not earn as much as a traditional CD to be of any relevance for a couple of reasons:
1. New issue bank/CU CDs are offering yields that are non-existent. To get even 1% you have to go out to 3 years today. For brokered CDs, for those who are limited to what is offered by their brokerage, the picture is even worse. To get 1%, 5 years is how far you need to go, 1 year is 0.15%, 2 year is 0.35%, and 3 year is 0.65%. When CD rates are so low, the opportunity cost of purchasing the market-linked CD is minimal. Yes, you may get 0% over the CD life. However, are you better off purchasing a traditional CD today, and guaranteeing you make no more than 1%?

2. You are getting market exposure with the guarantee of not losing any money. When interest rates are so low, you could not make a better pitch to fixed income investors. This is wonderful for folks like retirees who really do not want to be in the market, but also do not want to settle for 1% on CDs currently offered. Similarly, bond yields are also as pathetic, with risks that many are overlooking in chasing those yields, which are also at historical lows.

As far as returns being capped, or participation rates - just purchase those which provide the right combination of parameters. In another reply, I just posted the link to Fidelity's monthly offerings. This month Fidelity is offering 6 issues and they are based on different indexes and come with various participation rates. Those I'm purchasing this month come with 200% participation rate = double the index return and with no cap. The key is for the investor to understand the composition of the index used, how that index has performed historically, and how it may perform going forward. The market linked CDs have lengthy prospectuses associated with them, as they are considered "structured products". Like a bond investor, the market-linked CD purchaser should read the prospectus and understand the particular aspects of those being purchased. I personally purchase a small number of the market-linked CDs monthly, to diversify my holdings of them, and to provide a guaranteed future regular cash flow - no different than laddering traditional CDs. For those I first purchased two years ago, if they matured today, the annual returns would be in the 5% to 6% range. That is really wonderful performance relative to the comparable alternatives of CDs, savings accounts, and money market accounts (which actually could lose money and is not FDIC insured). The basis for comparison is not S&P/market returns, because we have the guarantee of no risk of losing principal.

Folks knocking these investments either do not completely understand them, or are not the type of investor who it is most beneficial for. I see the prime candidate investor being a fixed income investor who would be buying CDs if yields were higher, not wanting to be forced into investing in the market (not wanting to subscribe to "TINA"). For me, my investment objective is "Capital Preservation". I have enough to retire. I've won the game and see no reason to continue playing. I do not want the risk of having my investments in the stock market. I simply will not accept the potential of losing money. However, I do still want the ability/potential to generate returns above the piddly CD rates offered at this time.

My underlying belief is that there is absolutely nothing to lose here. The current economic/market conditions make the market-linked CDs an incredible opportunity at this time - interest rates excruciatingly low, and the markets performing extremely well. For the market-linked CD investor, in my view, it's win-win-win.

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