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.
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.
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.
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.
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.
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.