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plain-vanilla CDs are among the safest investment vehicles available in the market today. Not only do they offer a guaranteed fixed return over the life of the CD, they are also guaranteed by the FDIC up to a value of $250,000 – making them as secure as investing in government bonds provided that the insurance limit is not exceeded. However, given the relatively modest rates of return, CDs are designed to protect capital, and are not a growth fund, although some financial institutions have started to offer CDs whose returns are linked to increases in the stock market. These give a fixed coupon, as well as additional payments based upon stock market performance – since the issuer invests the capital into the market.
These market-linked CDs have been positioned as having all of the stability of a traditional CD, while providing the possibility of annual returns as high as 6 to 7%. However, a recent report by Securities Litigation & Consulting Group poses some fundamental questions about the risks and rewards associated with market linked CDs, and highlights that the value of these products is in fact 7% less than that of a fixed rate CD. This report comes in the wake of a 2012 warning from the FDIC about how market-linked CDs have extremely complex formulae when it comes to payments and carry other risk factors.
This raises the question whether or not a market-linked CD is something that investors should really consider – when you see highest apy on 2 year CDs, this type of traditional CD may be more attractive. In fact, the guaranteed fixed component of a market-linked CD can be as low as 0.25%, which is significantly lower than you would get with a plain-vanilla CD.

The first problem that investors face with market-linked CDs is the way that interest is paid on many of these products. It is common practice for banks and other financial institutions not to pay any interest on these until the CD has matured – and with market-linked CDs, the maturity period can be as much as 10 to 20 years. While this may be acceptable at first glance – especially if the CD is being used as a long-term investment vehicle – it can actually result in significant tax problems for the investor. While the interest does not pay out until maturity, investors will receive a tax bill each year for the interest that would be paid – even if this has not accrued. Furthermore, from a tax perspective, market-linked CDs are treated as fixed-income products, even though they are linked to equities. As a result, they are subject to income tax rather than being treated more favorably at a lower capital gains rate.

The fact that interest is only paid when a market-linked CD matures also creates additional risk. If the financial institution that issued the CD fails, the initial investment will be covered by the FDIC, but there is no coverage for lost interest, since it has not accrued. In other words, unlike a traditional CD, which pays out a coupon each year, the entire amount of interest due over the period of a market-linked CD is at risk.

Another concern is the real amount of upside in a market-linked CD. While these investments do protect against possible falls in the stock market – the initial investment is safe – they also limit the amount of gains that can be made. In most cases, there is a both a limit on percentage increases and a cap on absolute amounts paid. Therefore, it is entirely possible for a stock market index to rise 20% in one year and still only see a 6% return on a CD linked to that index. This is the bet that banks are making – they will protect against stock market losses while taking profits from any gains above a certain amount. While this does offer shelter from short-term stock market volatility, investors looking to capitalize on long-term stock market trends might do better to invest in an index fund.
Finally, one of the primary reasons for investing in a CD is to lock in interest rates for the long term. However, this advantage is often illusory when it comes to market-linked CDs. Many of these structured CD vehicles include a “call” clause in the fine print that allows a bank to close out the contract without any penalties, simply by paying back the principal and any outstanding interest. This means when rates fall – not that this is likely in the short term – the bank will simply terminate the CD.

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