Oct. 12, 2006
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 period.
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.