Following the financial crisis, bankers jumped at the opportunity to provide investments with the combined potential of the stock market with the safety of certificates of deposit. Market linked CDs (MLCDs) were the final product. And though they have been around for quite some time, MLCDs are never as popular as they are immediately following major stock market corrections.
So is a marketed linked CD right for you?
How Market Linked CDs Work
Market linked CDs provide:
- Security – As certificates of deposit are backed by the FDIC for up to $250,000, investors have protection in the event of a bank failure.
- Yield – Market linked CDs generally reward investors with a certain yield until maturity. As rates are currently near record lows, the upside here is very much limited.
- Market performance – Market linked CDs allow for upside relative to a stock or bond index. For example, a MLCD may give investors 1% per year plus the return of a popular stock index like the S&P500 from purchase to maturity.
Now, these three bullet points make MLCDs look like a phenomenal investment. But they are certainly not without their disadvantages. Here are just a few:
- Tax consequences – Certificates of Deposit are taxed as income, not capital gains. Thus, the returns of the MLCD are taxed at your marginal tax rate, not the long-term capital gains rate of 15%. You’ll have to report your earnings from your market linked CD each year whether or not the cash is paid out to you during the particular tax year. This means that you will pay taxes on the carried returns from year-to-year, not just in the year the CD matures. You can completely ignore this problem by keeping your MLCD in a retirement account.
- Limited Performance – Market linked CDs cannot simply give you a CD rate plus the performance of a particular index. There’s some give and take; usually, you receive the yield of a CD plus a portion of the returns of a stock index. You might receive 50% of the upside in the stock market, for example, or 100% of the returns up to a specific ceiling.
- Duration – You’re unlikely to find short-term market linked CDs; instead, terms longer than 2 years are most common.
- Withdrawal penalties – As expected, MLCDs have early withdrawal penalties just like an ordinary certificate of deposit.
Investing in an MLCD the Right Way
First of all, you likely won’t want to hold capital in a market linked CD unless you can hold it in a tax-deferred retirement account. Holding the CD in your taxable accounts reduces post-tax returns.
Also, always watch out for contingencies. Unlike a traditional CD, a market linked product is not as simple as an interest rate, principal amount, and maturity period. Market linked CDs change all the time, and each is a unique contract between you and the issuer. The complexity of the product and the bank’s hedging strategy often means that certain “triggers” will impact your total payout.
I think MLCDs really make sense in very specific circumstances where you have a certain amount of cash you will not have to touch for at least 2 years, and where the interest is not all that important to you. If you were stockpiling cash for a down payment on a home in the next few years, you might put the first of your savings in a market linked CD for 2 years while saving up the remainder. Who knows – a rising market may give you a little extra cash for moving expenses. If not, you’ll at least receive a return of principal. The opportunity cost is relatively small given that 2-year CDs yield only 1%.
The worst case scenario is zero return excluding inflation during the period. The best case scenario (depending on the markets and the contract) is the full return of the stock market during the period without any downside risk.
So what do you think?
Do you own an MLCD or variant?
Would you invest in a market linked CD?