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Some investors find market-linked CDs to be highly appealing. One of the most enticing characteristics of this investment is its ability to allow investors to access some of the best CD rates available — without any risk to the principal, should markets decline. Plus, like regular CDs, they’re FDIC-insured for added peace of mind.
However, market-linked CDs can be a bit tricky to understand. Here’s what you need to know to decide if this type of CD fits your investment goals.
What Are Market-Linked CDs?
A market-linked CD is a type of CD where your returns are tied to how certain markets, like the stock market or bond market, perform. For example, it might be linked to the Dow Jones or S&P 500. People also call these CDs by other names, including:
- Equity-linked CD
- Market-indexed CD
- Structured CD
- Index CD
How Market-Linked CDs Work
Market-linked CD rates and performance depend on the performance of the linked market or index. As the market goes up, so does the CD’s potential return.
Some, but not all, market-linked CDs guarantee a base return. However, if the market does well you’ll earn more — and if the market underperforms, your indexed CD might earn nothing at all.
This gives market-linked CDs a unique position in the marketplace. While offering potentially higher returns, they still offer the principal protection that most CD investors desire.
Key Benefits of Market-Linked CDs
Market-linked CDs come with a few benefits that investors should know.
Higher Earning Potential
Market-linked CDs have a participation rate that determines how much of the market’s growth you’ll earn. For example, if the market goes up 15% and your CD has a participation rate of 75%, you’ll earn 11.25% — which is 75% of 15%. A CD’s participation rate can be more or less than 100%, so make sure to read the fine print.
This is different from traditional CDs and savings accounts.
- Traditional CDs have a fixed interest rate. So you know how much you’ll earn when the CD matures.
- Savings accounts, on the other hand, also pay interest, but the rate can change with market conditions.
- Neither of these offers the potential for larger gains like a market-linked CD.
Portfolio Diversification
Combining traditional and market-linked CDs can give your investment portfolio a bit of variety. Both types protect your original deposit but they work differently:
- Traditional CDs pay a fixed interest rate.
- Market-linked CDs give you a chance to earn more if the market does well.
Principal Protection
The best feature of a market linked-CD is the guarantee of principal. All bank-issued CDs are insured by the FDIC for up to $250,000. This includes market-linked CDs as well. So, while there is potential upside with a market-linked CD, there is no risk to principal.
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Who Should Consider Market-Linked CDs?
Market-linked CDs can be a good fit for certain types of investors, including:
- Conservative investors who want the chance to earn more without risking the original deposit.
- Retirees or those nearing retirement who might have a lower risk tolerance but are still seeking growth.
- Anyone seeking variety in their investments by adding a low-risk option with growth potential.
Comparing Market-Linked CDs to Traditional CDs
Here’s a side by side comparison of market-linked CDs vs. traditional CDs.
| Type of CD | Risk | Returns | Liquidity |
|---|---|---|---|
| Traditional CD | Low | Fixed, low-to-moderate | Can typically be sold before maturity, but with a penalty of a few months’ interest. |
| Market-Linked CD | Low | Variable. Offers the potential for higher returns but could return as little as zero. | Not a guarantee that can be sold prior to maturity; if available, could result in a loss. |
If you’re looking for a guaranteed rate of return with regular interest payments, a traditional CD is likely a better option for you.
If you’re looking to preserve your original deposit and are hoping for greater returns, a market-linked CD is preferable.
Tax Implications of Market-Linked CDs
One of the big negatives of market-linked CDs is that they subject the owners to tax on “phantom income.” Phantom income is money that you earn but aren’t actually paid.
For example, if your CD earns 5% in a year, that gain gets added to the value of the CD but isn’t paid out to you. Even so, the IRS treats it as taxable income, so you’ll need to pay tax on it annually.
Additionally, even if you generate capital gains on your market-linked CD, all of the profits you receive are still taxed as ordinary income. This is a definite negative — as if you invested directly in the stock market, gains you earned over periods longer than one year would benefit from a reduced tax rate, perhaps as low as zero. But ordinary federal income taxes alone could top out at a 37% rate.
For this reason, many investors choose to hold market-linked CDs in tax-advantaged accounts, like IRAs. This way, taxes are not paid on an annual basis, but only when they are withdrawn from the account.
Tips for Choosing the Right Market-Linked CD
Here are a few tips to help you choose the best market-linked CD for your needs:
- Assess your risk tolerance and investment goals: Even though they have the name “CD” in their description, market-linked CDs are a completely different investment type than traditional CDs. While both are appropriate for investors with lower risk tolerances, traditional CDs are generally for income investors, while market-linked CDs offer the potential for limited growth.
- Use online tools to compare CD options: The financial services market is extremely competitive. You can likely find a wide variety of features and benefits, such as participation rates, term lengths and withdrawal options, if you shop around.
- Look for trusted banks and well-defined terms: As market-linked CD are specialty products, it’s generally best to stick with well-known, trusted banks. Since each bank can essentially create its own CD terms, you’ll want to avoid banks and products that don’t specifically outline exactly what you’re getting if you invest in a market-linked CD.
FAQ
Here are the answers to some of the most frequently asked questions about market-linked CDs.- What is the difference between a market-linked CD and a traditional CD?
- A market-linked CD is where your returns are tied to how certain markets, like the stock market or bond market, perform. A traditional CD, on the other hand, is an income investment. In addition to carrying FDIC insurance on its principal, a traditional CD guarantees to pay a set rate of interest over a specified maturity.
- Are market-linked CDs FDIC-insured?
- Yes, market-linked CDs carry the same FDIC insurance as traditional CDs and savings accounts. This means that your market-linked CD is insured up to $250,000 per issuer, per depositor, per account ownership category.
- What happens if the market performs poorly?
- As long as you hold your market-linked CD to maturity, you cannot lose money on your principal, regardless of how the market performs. If the market drops during the period that you own a market-linked CD, your return will be zero, not negative.
- Can I withdraw funds early from a market-linked CD?
- Most market-linked CDs do not allow for early withdrawal. However, some indexed CDs might enable a deceased depositor’s survivors to redeem the full value early without paying a penalty.
- You may also be able to sell the CD to other investors on the secondary market. While there is no specific “early withdrawal penalty,” as with a traditional CD, you should expect to lose some money on the transaction if you’re looking to get out of your market-linked CD before maturity.
- Are market-linked CDs better than stocks or bonds?
- “Better” is a relative term, particularly when it comes to investments. What is good for one investor may not be the right choice for another.
- Over the long term, stocks usually offer higher returns than market-linked CDs. However, market-linked CDs limit how much you can earn because of the participation rate caps. For someone who doesn’t want to risk losing money, a market-linked CD might feel like the “better” option because it guarantees your original deposit.
- Bonds may pay higher interest rates, but they also come with the risk of losing value if market conditions change. A market-linked CD can be safer, as it protects your principal while still giving you growth potential.
Barri Segal contributed to the reporting for this article.
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