What Is a Market-Linked CD?
A market-linked certificate of deposit (CD), also called an indexed or equity-linked CD, is a type of CD where the rate of return is based on either a market index, a basket of equities, or a combination of the two.
When the market is doing well, so is the return on the CD. But keep in mind that the CD’s performance will decline when the market drops.
Market-linked CDs usually have longer maturities than traditional CDs. As with other CDs, market-linked CDs are FDIC-insured up to the legal limit of $250,000.
How Do Market-Linked CDs Work?
The return on a regular CD reflects its fixed interest rate. In contrast, a market-linked CD’s return is defined by the performance of its attached index and by the extent to which it reflects or participates in that performance.
This is because market-linked CDs are usually subject to an interest cap, which sets a limit on the percentage of growth the CD can earn and protects the issuer should the index experience unusual growth.
The investor incurs penalties for cashing out a market-linked CD before maturity. However, market-linked CDs can be redeemed or “called” by the issuing bank before its maturity date. The investment will have a call price, which determines how much is earned in the event the bank redeems the CD early.
How to Calculate the Return from a Market-Linked CD
There are several ways to calculate a market-linked CD’s performance:
- Participation rate. Let’s say an index sees a gain of 10% and the CD has a participation rate of 90%. The CD won’t reflect the 10% market gain. Rather, the CD will see a gain of 9%, or 90% of 10%. It is also possible for the participation rate to exceed 100%.
- Point to point. The starting point is the value of the index when the CD is issued. The second point is the value of the index on a date right before its maturity date. The difference between these two numbers, or a percentage of that difference, will indicate the CD’s return.
- Average method. This takes the average of different values of the index. These values can be pulled from several different dates, or points, throughout the CD’s term.
Market-Linked CD Pros and Cons
Market-Linked CD Pros
- Market-linked CDs usually pay higher rates than conventional, fixed-rate CDs.
- Market-linked CDs still offer the same FDIC insurance protection and can provide an easy means for bank customers with substantial assets to keep all of their CD money under the safety of the FDIC umbrella.
- Market-linked CDs offer a relatively low-risk method of investing in the market that does not require investors to defer their money until retirement like market-linked annuities.
Market-Linked CD Cons
As mentioned above, market-linked CDs contain call features that allow the issuer to recall them at a certain price or time frame. This shifts more risk onto the investor.
Cashing in the market-linked CD to access the funds early can incur severe withdrawal penalties. Many market-linked CDs require a high initial investment, such as $25,000 or even as much as $100,000.
Is a Market-Linked CD Right for You?
Despite the disadvantages, there is still a potential upside in investing in a CD that is based on index performance. Check out our updated list to see which bank is offering the best value in CDs right now.
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