Going Hybrid with Equity-Linked Certificates of Deposit
There are two sides to stock market volatility. On the one hand, steep losses in a year like 2008 scare many people away from investing. On the other hand, it is after those declines that securities are cheapest and may represent the best opportunity. Investors trying to choose between avoiding volatility and capturing market opportunity might be intrigued by an investment vehicle which offers some of the stability of certificates of deposit (CDs) along with some of the upside of the stock market.
These vehicles are called equity-linked CDs, or equity-indexed CDs. Like ordinary CDs, these are FDIC-insured bank products which offer a guaranteed return of principal if you hold them until maturity (which is typically five years from the original issue date). In addition, at maturity they pay you some portion of the stock market's return over the period for which you held the CD.
Guaranteed principal with equity participation--isn't that the best of both worlds? Maybe--the devil is in the details. The specific terms of market-linked CDs make all the difference. Here are five things you should know about those terms:
- What is the index? Equity-linked CDs can be tied to different types of equities, so choose one based on the specific stock index, such as the S&P 500, that offers the returns you want to capture.
- How much participation do you get? These instruments give you a percentage of the stock index's performance, which may mean just the price change rather than the total return. Don't expect 100% participation, but the lower that percentage is, the less of the market you are actually capturing.
- Is there a cap on your gains? Besides only paying you a portion of the market's return, some market-linked CDs limit how high a return they will pay you.
- How is the gain calculated? Some of these instruments base the gain calculation on an average of the index value over the holding period, which can water down the return under some circumstances.
- How solid is the guarantee? If you are making a large investment, be sure to check out applicable FDIC insurance limits, because you don't want to rely purely on the soundness of the bank issuing the CD.
Other similar products you might consider are called equity-indexed annuities. Equity-indexed annuities may offer some favorable tax treatment, but they can also add an expensive layer of fees compared to equity-linked CDs.
One problem with this type of hybrid instrument is that it is difficult to fit into a traditional asset allocation strategy. It doesn't have the liquidity of cash, the guaranteed interest of fixed income, nor the full upside of equities.
The bottom line on market-linked CDs and annuities is that the specific terms make all the difference in how attractive they are. The key is the market participation--the less limited that is, the better the deal for you.