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Review of a Market-Linked CD

Triston Martin

Jan 22, 2024

Investment returns for a market-linked CD can be calculated from the performance of a particular stock index or market index, such as the S&P 500. There are several different names for these certificates of deposit, but they all refer to the same thing. The Federal Deposit Insurance Corporation (FDIC) insures market-linked CDs up to $250,000 in principle, with several restrictions.

It seems like an excellent deal at first appearance, with diversification, returns dependent on the market, and principal protection. When compared to the low rates given by traditional CDs, the deal seems even more attractive. As of August 16, 2021, the average return on a conventional, non-jumbo CD with a 60-month term was just 0.27%.

The return on a market-linked CD is tied to the performance of a market index or basket of stocks, such as the S&P 500. However, many equity-linked certificates of deposit fail to match the returns of more conventional certificates of deposit.

There are restrictions, however. Market-linked certificates of deposit (CDs) underperformed traditional CDs after fees, restrictions, and other factors were considered, according to research published in the Wall Street Journal in September 2016. The report looked at the performance of 147 market-linked CDs published since 2010 and found that 62% of them lagged behind traditional CDs.

Premature withdrawal fees

You may be subject to a hefty penalty if you withdraw money from your CD before its maturity date. Any interest generated may be nullified by the imposed penalty. The Securities and Exchange Commission warns that it can lead to a complete loss of investment in extreme situations (SEC).

Interest-taxable returns

Even when the value of your CD rises and falls with the market, any earnings are still attractive. Instead of paying the significantly reduced long-term capital gains taxes that stock investors pay, you will likely have to pay income taxes instead. Plus, even if interest is only paid at maturity, it must still be declared annually. That makes it more challenging to hold onto a market-linked CD. If you want to put off having to pay taxes every year, you might put your market-linked CD into a tax-deferred account like an IRA.

When investing in a market-linked CD, it's essential to spread your money around and stay away from anything too risky. Be aware of all costs, but up-front ones in particular.

Potential Gains Are Limited

In other words, if the stock market significantly increases in value while your CD is active, you will not reap the full benefits of that growth. The reason is the standard limit placed on returns in market-linked certificates of deposit. There could be a cap on total profits made, or they could only pay out a certain proportion of every price increase. Limits on price increases expressed as a percentage are known as "participation rates." An "interest cap" refers to a ceiling on earnings.

Fourth Possibility of a Call

The ability to "call in" your investment is a feature of several market-linked CDs. Thanks to this feature, the issuing institution, usually a bank, can cash in the CD before its maturity date. Depending on the CD's call price, you may earn less income than if you kept it in the account until maturity. The issuer of a market-linked certificate of deposit is under no obligation to make a redemption.

The issuer will likely initiate a call of the investment when doing so would be financially beneficial. For example, if your investment is called, you might be unable to reinvest the money at the same rate.

Reasons Why There Are No Dividends

Unlike conventional CDs, market-linked CDs do not pay dividends. Unlike mutual funds, dividends are not automatically reinvested. One potential drawback is that the investor cannot reinvest dividends. Some investors don't hesitate, prioritizing benefits like the safety of investment capital and assured profits.

In the event of a market decline, even if your market-linked CD has a guaranteed return, the net gain may be lower than a traditional CD. You should be aware that not all market-linked CDs provide a guaranteed rate of return. When the market falls, having only principle protection could leave you with nothing but your initial investment.

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