An equity-linked CD is an FDIC-insured certificate of deposit
that ties the rate of return to the performance of a stock index such as the
S&P 500 Composite Stock Price Index. The terms of these CDs vary;
typically the term is five years. The financial institution calculates your
rate of return on the date that the CD matures based on the particular terms of
the contract. Therefore, there is no guarantee that any payment in excess of
the guaranteed payment will be paid. As with any CD, you should understand its
terms, verify whether the institution offering the CD is reputable, and assess
whether the CD is an appropriate investment for you.
Financial institutions offering equity-linked CDs typically
emphasize that the products protect investors from downturns in the markets
because the original principal is not at risk. The investor is risking the
interest that would otherwise be paid on the CD for the term. However, before
you invest in these CDs, you should fully understand how their specific
features may affect your return and the tax treatment of these products. The
offering institution typically outlines this information in the term sheet and
the general terms and conditions.
- Liquidity Risk. Investors typically will have limited
opportunities, if any to redeem their equity-linked CDs prior to maturity.
Moreover, the financial institutions do not guarantee the existence of a
secondary market. Many equity-linked CDs do not permit the early
withdrawal of your investment without the consent of the financial
institution. If you need to withdraw your investment before the CD matures,
you will incur withdrawal penalties. You also will lose any interest that you would
accrue in a regular CD that has the same terms. There is no exception for CDs
held in either a traditional IRA account or a Coverdell Education Savings
Account (CSA). Therefore, you should carefully consider your retirement needs
or the educational needs of a beneficiary of a CSA before investing in
equity-linked CDs. Other equity-linked CDs allow for redemption only on
pre-specified redemption dates. Therefore, you may not be able to redeem your
equity-linked CD when you may want or need your money to be available.
- Market Risk. If the equity-linked CD is sold before
maturity, it may be worth less than its purchase amount or face value. The
equity-linked CD will be subject to a number of variables, including stock
market volatility and changes to the components of the linked index. In
addition, there is no guarantee of principal return unless the investment is
held to maturity.
- Call Risk. An equity-linked CD may be callable. If an
equity-linked CD is called, the investor’s return may be less than the yield
for which the CD would have earned had it been held to maturity. The investor
also may not be able to invest their funds at the same rate as the original CD.
- FDIC Insurance. In general, equity-linked CDs are insured
by the FDIC up to the amount permitted by law. FDIC insurance covers the
principal of, and any guaranteed interest on, the equity-linked CDs. Investors
should carefully read the issuer’s disclosure about how the FDIC limits apply
in specific circumstances. Investors also may want to review the FDIC’s
brochure entitled “Your Insured Deposits.”
- Calculation of Return. Many financial institutions
calculate the return on an equity-linked CD by averaging the closing price of
the underlying index over a specific period of time, rather than simply using
the closing price upon maturity of your CD to compute your gain or loss. For
example, a financial institution may use an average based on the closing price
of the S&P 500 every six months during the term of the CD. The formulas
used to calculate your return may lessen the impact of a declining market.
However, if the market moves steadily upward during the period that you hold
the CD, your return may be significantly less than the index’s gain during this
The formulas used by the
financial institutions usually do not take into consideration the dividend
yield of the relevant stock index.
- Participation Rates. The participation rate determines
how much of the index’s increase will be used to compute the interest
calculation. For example, if the S&P 500 goes up 10 percent and the
participation rate is 70%, you will get only 7 percent.
- Caps. Some equity-linked CDs also set a cap on your gain
per year regardless of how well the relevant stock index performed. For
example, if the S&P 500 goes up 20 percent and the CD participation rate is
70%, but the cap is 10%, your return will not be 14% (70% of 20 percent), but
will be capped at 10%.
- Tax Treatment. Equity-linked CDs may be treated
differently than traditional CDs for tax purposes. Before investing in these
products, you should carefully review the disclosures concerning the reporting
of interest income and consult a tax adviser if appropriate.