Table of Contents
A market-linked certificate of deposit (MLCD) tracks a basket of underlying securities, or an index, such as the S&P 500. They differ from traditional certificates of deposit (CDs), which generally pay a fixed rate of interest. These accounts are sometimes called equity-linked CDs or market-indexed CDs.
A market-linked CD is similar to a traditional CD in that it’s a time-deposit account with a fixed term, during which the investor’s funds are unavailable. The principal is federally insured by the Federal Deposit Insurance Corporation (FDIC). But market-linked CDs come with some risks, including the possibility of zero gains at maturity.
Key Points
• A market-linked CD is a type of savings product whose returns are tied to the performance of an underlying market index rather than a fixed interest rate.
• Market-linked CDs offer principal protection if held to maturity, meaning investors generally receive at least their initial investment back.
• Returns on these products are frequently capped or based on a participation rate, limiting how much investors can gain, even if the market performs strongly.
• Market-linked CDs usually have fixed terms, and early withdrawal can result in penalties or reduced returns, making them less liquid than other savings vehicles.
• They are often used by more conservative investors who want exposure to potential market upside while still limiting downside risk.
What Is a Market-Linked CD?
A market-linked CD tracks an underlying index or collection of securities, rather than paying a fixed rate of interest. When investing in traditional CDs, the CD investor can deposit their funds for a specified term (typically a few months to a few years), and generally count on a steady rate of return until the CD reaches maturity.
Traditional CD’s total return is unlikely to be high, especially when comparing deposit accounts, because it’s based on current interest rates, but there’s little to no market risk. Certificates of deposit are federally insured, whether by a bank or a credit union, for up to $250,000 per depositor, per account ownership category, per insured financial institution. For this reason, traditional CDs are considered a fairly low-return, low-risk investment.
Market-linked CDs share some of these features, e.g., the investor deposits funds for a set period of time (often between one to seven years), and the funds are unavailable until the CD matures. But the returns of an MLCD are, as the name suggests, linked to the stock market, which adds in a layer of potential reward, but also potential risk.
Unlike traditional CDs, which are considered cash equivalents, market-linked CDs are bank deposits with a return profile similar to securities. The reason for creating market-linked CDs goes back to the days when banks couldn’t sell securities, and these products offered investors a workaround.
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How Do Market-Linked CDs Work?
Unlike traditional CDs, market-linked CDs don’t offer fixed interest payments. Rather, the return is based on the underlying investments or market index that the CD tracks. Some of these market benchmarks include equity, commodity indexes, or a basket of commodities or currencies. But investors don’t see precisely the same gains and losses as the market.
Typically, the upside of MLCDs is capped in one of two ways:
• Participation rate: This determines the percentage of market gains you receive. For example, an 80% participation rate means you receive only 80% of the gains from the underlying market.
• Interest cap: This sets a maximum limit on the total return, regardless of how well the underlying market performs.
Fortunately, the principal amount deposited in the CD is protected if it’s held until maturity, at which point investors will get their full deposit back. But if the market underperforms, the CD may not have any gains. In other words, at maturity, there’s no guarantee your return will be more than your deposit amount.
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How to Calculate the Return of a Market-Linked CD
To calculate the return of a market-linked CD, financial institutions may average out the closing price of the underlying index over a certain period of time. For this method, you may receive the average of the index’s different values over a six-month period.
Another method that financial institutions may use is the point-to-point method, which involves identifying two values. The first is the value of the index when the market-linked CD was issued, and the other is the value of the index before the CD’s maturity date, which is referred to as the ending point. The difference between these two values will yield the expected return on your market-linked CD.
The final return also assumes that the funds are left in the CD until maturity. Withdrawing funds earlier than the maturity date — whether that’s two months or 20 years — will likely trigger early withdrawal penalties.
Pros of Market-Linked CDs
Market-linked CDs have several favorable characteristics that may be appealing to investors. They can be an alternative to conventional CDs for those seeking exposure to the stock market, without taking on too much investment risk.
• Protection: Market-linked CDs protect your principal and, when held to maturity, the principal is backed by the bank that issues it. In the scenario where the underlying market declines during the period when you hold the CD, investors are protected from the loss of principal.
• Insurance: Market-linked CDs are also insured by the FDIC or the National Credit Union Administration (NCUA) for the principal investment (but not investment earnings).
• Potential for greater returns: Market-linked CDs have the ability to provide investors with higher returns than traditional CDs. Because the underlying asset is based on a collection of stocks, commodities, or indexes, there’s a chance MLCDs may outperform traditional CDs.
• Return on original deposit: At time of maturity, you’ll get the full amount of your original deposit regardless of the performance of the underlying market index or securities. If you choose to attempt to sell your market-linked CD prior to maturity on the secondary market — if one exists, which is often not the case — there’s no guarantee that you’ll get the full amount of your principal back. MLCDs are primarily considered buy-and-hold financial instruments.
Cons of Market-Linked CDs
Investors must also consider the risks associated with holding market-linked CDs.
• Liquidity risk: Investors must be aware that when opening a market-linked CD, they are locking up their money for a period of time, and they should be willing to hold on to the CD through its maturity to achieve the full benefits. If you need access to the capital in the CD and want to withdraw money, if permitted, the penalties can be significant, including potential loss of principal.
• Market risk: Market-linked CDs that are linked to the equity markets are subject to volatility, which can impact the MLCD returns.
• Taxes: MLCD earnings are taxed as interest income, not as capital gains, and thus investors will pay a higher rate for their earnings. Also, interest must be reported annually, even though it’s not paid until maturity.
• Potential for little or no profit: It’s possible to hold an MLCD to maturity, but not making a profit. Even though your original principal will be protected, there’s no guarantee that you’ll make more than your deposit amount.
You may have the possibility of seeing greater gains if you invest your money directly in an index fund or exchange-traded fund (ETF), which can provide similar diversification benefits. However, investing directly in the market comes with higher risk and it’s possible you may lose your principal in addition to any potential gains.
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How to Open a Market-Linked CD
Opening a market-linked CD is fairly straightforward. Here are the typical steps involved.
• At the financial institution of your choosing, you can open a market-linked certificate of deposit by selecting the underlying asset and maturity date from among predefined products.
• Next, deposit the amount of money you’re able to lock up for a period of time.
• Some market-linked CDs have a minimum investment requirement and a maximum deposit limit per account, which must be considered.
Alternatives to a Market-Linked CD
Alternatives to market-linked CDs could include investing in a bond fund. Similar to a CD, bond funds have different maturity dates, either short-term or long-term, and may offer competitive yields. Depending on the creditworthiness of the bonds and the overall economic environment, the yield can vary. Bonds with a high credit rating, which are lower risk, may have a lower yield than bonds with a lower credit rating, but the latter may come with higher risk. The choice of a bond fund depends on the investor’s risk tolerance.
Investors may also consider a high-yield savings account, which is lower risk but usually yields less than a market-linked CD. These types of accounts are more for emergency funds, but if you’re looking for the lower risk options to store your cash, high-yield savings accounts can be another alternative to a market-linked CD.
When to Consider Investing in Market-Linked CDs
Investors may be interested in a market-linked CD if they’re looking for an alternative to a traditional CD and the potential for higher, market-based returns. Market-linked CDs may also offer some diversification alongside protection of principal investment.
If you’re looking for exposure to the broader stock market with managed risk, a marked-linked CD may be a suitable option because it’s viewed as an alternative to directly investing in the stock market. That said, market-linked CDs are insured products and aren’t considered securities. In addition, they can involve greater risk than traditionals CDs since the returns are tied to market activity vs. a fixed interest rate.
The Takeaway
Market-linked CDs are, as the name implies, a sort of hybrid savings-investment option. They offer some of the features of traditional CDs: You deposit your money for a fixed period of time and your principal is typically federally insured by the FDIC. You also face an early withdrawal penalty if you withdraw funds before the maturity date.
However, because MLCDs are market-linked, its performance is tied to underlying securities or a market index. Returns can fluctuate, unlike the fixed interest rates that CDs typically provide. MLCDs are also typically capped in terms of the gains they can provide. Finally, like any other investment in the markets, there’s no guarantee that a market-linked CD will see a profit by the time it matures.
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FAQ
What is a market-linked CD?
Market-linked CDs are certificates of deposit that can be linked to stocks, commodities, an index, or a mix of these, depending on the type of return the investor is seeking and their risk tolerance. Returns are typically tied to the performance of the underlying market benchmark rather than a fixed interest rate, which distinguishes them from traditional CDs.
Is a market-linked CD a security?
No. A market-linked CD is federally insured in the event of bank failure or fraud, so your principal is protected up to $250,000 per depositor, per account ownership category, per insured bank, if you hold the CD until maturity. Insured products aren’t considered securities.
What is a stock market CD?
A stock market CD is another name for a market-linked CD and is linked to a broad stock market index, such as the S&P 500. This means the CD’s performance will adjust as the index changes.
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