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What Are Market-Linked CDs?

A certificate of deposit (CD) can be one of the best low-risk savings vehicles that you can use, with higher interest rates than savings accounts.

Market-linked CDs (MLCDs), are a lesser known and less common type of CD account. Market-linked CDs are tied to a market measure or asset (e.g., the S&P 500, a bond index, foreign currency market, etc.) with different investment risks and benefits.

The benefit of an MLCD is the guarantee for the return of your original deposit at maturity, up to FDIC insurance limits, even if the market measure has decreased.

You should not think of an MLCD as a replacement for income-producing CDs, but as a long-term investment strategy.

 You can often find MLCDs offered by brokerage firms.

Examples of banks that provide them include:

  • Wells Fargo
  • Union Bank
  • TIAA Bank

We've broken down the basics behind MLCDs in this article.

What Are MCLDs?

MLCDs can be confusing because they have a number of names, including indexed CDs, structured CDs, equity-linked CDs, and market-indexed CDs.

Merrill Lynch called their version of MLCDs, “Market Participation Certificates of Deposit.”

In the simplest terms, an MLCD offers you potential gains from the growth of a market, while protecting you from losses.

The payout structures can be complex and limited. There is no fixed APY like regular bank CDs.

For example, an MCLD may be linked to a foreign exchange (Forex) market. The Forex market may be up 16%, but due to a market cap, your return may be subject to a 5% or 10% cap either on a quarterly basis and/or on the overall return potential at maturity.

However, if the Forex market falls 16%, you still receive 100% of your principal investment at maturity.

Terms associated with Market-Linked CDs:

Maturity date

Like a standard CD, a maturity date is the fixed date of withdrawal at the end of a MLCD term. You will choose, and know, the maturity date when you open the CD.

Your term length options will vary from bank to bank. Wells Fargo offers MLCDs for terms between two and 10 years.

Limited upside

Typically, a cap is placed on how much interest an investor can earn, making the upside potential with an indexed CD less than investing in the asset class directly. This cap is essentially the price that you pay for having a guaranteed investment.

Term length

The term length is the specific amount of time from when you open a CD to the maturity date, which is when you receive the return of the original deposit. It may be several years to over a decade.

Survivor’s option

In the event of the death of the owner of an MLCD, a “survivor’s option” or “estate feature” allows the CD owner’s estate to withdraw the original deposit amount, prior to maturity.

Pay close attention to the terms of your account, as it is possible that your death would be the only early access to your funds without penalty.

Minimum investment

The minimum amount of funding required to open MLCD will vary from bank to bank. For example, Wells Fargo requires a minimum investment of $1,000. Union Bank requires a $4,000 minimum investment, which may be increased in increments of $1,000.

FDIC insured

The FDIC standard maximum deposit insurance amount is $250,000 per depositor per FDIC-insured institution (was increased from $100,000 in 2008).

Most banking institutions and financial advisors recommend that you monitor how much you are investing to stay within FDIC insurance limits.

Call risk

The risk that a bond issuer will redeem the issue prior to maturity. If the issuer exercises the right, you may not be able to reinvest the proceeds at the same yield.

Call feature

A clause that allows the issuing financial institution to redeem the CD before it matures. If that happens you will be paid the call price. This could be less than you would have been paid if you held the CD until its maturity date.

Figuring Out Your Return: Point-to-Point Return vs. Average Return

Although Market-linked CDs prove to be a complex form of investing, determining the return is a fairly simple process.

Point-to-point return

The return on your MCLD may be based on the difference between the value of the index when your CD is issued versus the value of the index on a pre-determined date before the account matures.

Average return

The return may be calculated on the average value of the market measure on predetermined dates (maybe annually, quarterly, or monthly).

Advantages of Market-Linked CDs

Although not every bank offers MLCDs, they are becoming increasingly popular, for various beneficial reasons.

Convenience

Market-linked CDs are designed with the investor in mind. So this means that they are built to help protect you against market risk losses, if you hold on to it until it reaches maturity. 

Return Diversification 

Historically, they tend to sell better in times of high market volatility, as investors sitting on large sums of money are looking for ways to invest without risk of loss of principal.

Potential Big Returns

If the market is doing increasingly well, then you are essentially guaranteed a return on your investment -- and a large one at that. 

Disadvantages of Market-Linked CDs

Most bank disclosure statements, similar to mutual fund prospectus documents, will advise you that MLCDs are not suitable for all investors.

It is possible you will make nothing

There is no assurance of any return on investment above the deposit amount.

Although you have the advantage of protection of your principal (assuming your account is within FDIC limits), if the market goes down, at the end of the term limit, you will receive your principal, and nothing more.

If you have more money invested beyond the FDIC limit, and the issuing bank cannot pay its debts or goes bankrupt, you may not be paid for the portion above FDIC limits.

So, investing beyond the FDIC limit does come with some risk to the investor.

More gains possible through an index fund or ETF

Your disclosure statement may warn you that an MLCD not an appropriate investment for someone desiring a return based solely on the appreciation of a particular index.

By investing in the index fund or ETF tied to an index, you are not subject to the cap on investment returns.

Money loss if you need to liquidate early

Although there may be exceptions if you pass away or are judged legally incompetent, financial penalties may be significant should you need to liquidate the account, because your MLCD is tied to a specific market.

This is the same as an early withdrawal penalty on a standard CD.

Read the disclosure carefully and understand that early redemption may cause loss of principal.

Union Bank’s MLCD disclosure specifically states, “funds needed prior to maturity should not be invested in a Market-Linked CD.”

Pay taxes on income not yet received

MLCDs are subject to complex federal income tax rules known as original issue discount (OID) rules.

Talk to your tax advisor about how you may have to pay interest you have earned, but not received.

The Risks to Be Aware Of

Market-linked CDs involve a variety of risks, payout structures, and underlying market measures to be concerned about. We've highlighted the biggest ones you should be aware of. 

Timing is an issue 

Your account may be up, and then the market may plummet a short time before your CD matures, leaving you with nothing other than the principal.

Limited upside

Of course, how much you lose will depend on how your payment is calculated (point-to-point calculation, averaging calculation, or the sum of periodic returns). The limited upside means that if the market is much higher than your cap, you will not receive any additional interest than your cap.

Some financial advisors will warn you that the likelihood of running into a cap on returns is high.

Market value uncertainty and liquidity risks

You may also be able to sell your MLCD on the secondary market, but your financial institution will not be required to purchase your investments from you.

If you buy or sell MLCDs on the secondary market, you may pay trading commission or markup fees.

Tax Implications of Market-Linked CDs

Interest paid on standard CDs should generally be taxable as ordinary income, and gain or loss from a sale or exchange will be taxed as capital gain or loss.

With an MLCD, returns are considered interest, not capital gains.

This means the tax rate will be much higher than what you would pay on capital gains.

Even though it is only paid at maturity, it is declared only at maturity.

To avoid these annual taxes, you may be able to hold your market-linked CD in an IRA, which is tax-deferred until your retirement.

Major Differences Between Standard CD and Market-Linked CDs?

An MLCD is an investment created to meet specific financial goals.

Compared to standard CDs, MLCDs are typically for longer terms, years, instead of months.

A standard CD will typically give you a snapshot of how much money you will make, when the account matures, known as Total Projected interest.

It is an accurate estimate of the total interest you will earn over the term of your CD, assuming that your account balance will stay content for the length of the term.

Conclusion: Is a Market-Linked CD for You?

An MLCD may be for you if you want to invest in the stock market without the possibility of losing out on initial principal, especially if you want to invest in a high-risk asset class, such as a commodities ETF.

The potential upside of an MLCD does not necessarily make it better than a standard certificate of deposit with a guaranteed return.

Be especially mindful of the consequences involved should you need access to your money prior to the maturity date.

Before you make any investment, speak with a knowledgeable banking professional or financial advisor to discuss the risks, benefits, and tax consequences.