Equity-linked CDs offer potentially higher yields than traditional CDs. Are they worth the risk?
Equity-linked CDs offer potentially higher returns than traditional bank CDs in an era of historically low interest rates, but investors who buy the products take on greater risk in the quest for yields.
The demand for equity-linked CDs and other types of market-linked certificates of deposit has surged, according to Bankrate.com, which notes that bank revenue for the products more than tripled in October compared to January of last year. The products offer advantages, but should be approached with caution, said Bankrate contributor Claes Bell. “I think CD investors have to be extremely careful with products like these. While they’re called CDs, these products don’t have much in common with a conventional certificate of deposit beyond revenue.”
Federal regulators express similar concerns. An equity-linked CD is tied to the performance of a stock index, such as the S&P 500, and makes no guarantees beyond the return of an investor’s original principal, explains the U.S. Securities Exchange Commission in an investor advisory. A bear market can wipe out interest payments resulting in a lower return than that from a traditional CD. The agency advises, “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.”
Equity-linked CDs appeal to conservative investors because they offer exposure to the stock market, but can also protect against market downsides. The Federal Deposit Insurance Corporation, or FDIC, guarantees deposits of up to $250,000 made with participating institution. While the original principal may be protected, equity-linked CDs pose other types of investment risk, warns the SEC.
Market risk still applies to equity-linked CDs that are sold before their maturity date, said the SEC, because principal guarantees apply only to investments held to maturity. As a result, equity-linked CDS sold before the end-date may be worth less than face value as the underlying investment is subject to market volatility and other factors.
Liquidity risk describes the limited opportunities for investors to redeem equity-linked CDs prior to maturity. Most equity-linked CDs have a five-year maturity date and impose penalties, including a forfeit on any interest, for early redemptions, said the SEC. The agency also notes that while FDIC insurance covers principal and any promised interest, limits apply in some circumstances. The products are also subject to call risk. An equity-linked CD called early may yield less than if it had been held to maturity. Investors may not be able to invest their funds at the same rate as the original CD.
Returns on equity-linked CDs are calculated according to formulas that may limit the extent an investor can benefit from market gains. The limits are referred to as “participation rates” and stipulate an investor’s share of investment gains. Caps can also be imposed to limit an investor’s annual gain, regardless of how well the underlying index performs. Investors may also suffer a negative tax consequence because the interest from an equity-linked CD is taxed as interest not a capital gain, said the SEC.
The products may be appropriate for investors who can afford to tie up their money for the duration of the CD, but can’t afford to risk their principal and are willing to sacrifice the “full upside” of the stock market in exchange for security, according to USA Today.
An equity-linked CD may also help investors diversify their portfolios because they can be invested in a variety of markets, including international equities and commodities, states an investor guide from Wells Fargo, a provider of the products. But, warns the bank, equity-linked CDs are not suitable for short-term trading since there is no established secondary market for the products.