A market link CD is a certificate of deposit with an interest rate determined by changes in an underlying index or common benchmark. The underlying index can cover almost any type of asset.
Market linked or market based bank CDs may include returns that are based on equity indexes, commodity indexes, foreign currencies or any number of other investment instruments or indexes. Market linked bank CDs allow investors to take advantage of potential appreciation of the reference assets, such as a basket of stocks or foreign currencies and more.
These bank CDs are not conventional CDs. The CDs rate of return is ascertained upon maturity and do not provide the account holders with a return or income stream prior to their maturity. The market kinked CD combines the long term growth potential of equity or other markets with the safety and security of a traditional certificate of deposit.
The principal invested in a market linked CDs is insured by the Federal Deposit Insurance Corporation up to applicable limits and is therefore protected from any market volatility. The principal protection assumes the CD is held to maturity and the insurance covers only the principal investment amount.
The CD maturities will vary with each bank offering, most market linked CDs are intermediate or long term CDs. Early redemptions form these types of CDs are typically not permitted and may result in a substantial loss of principal.
The interest rate earned on the CD is tied to an index. The interest payment to the depositor will vary depending on the terms of the specific CD. In general, the CD return is equal to the appreciation of the benchmark or index over the term of the CD with certain conditions. The conditions will vary depending on the terms of the CD but it is common for the returns to have caps that restrict the highest available rate of return regardless of how much the index my appreciate as well as floors that are in place restricting and principal reduction regardless of how much the index value may drop.
A market linked CD may yield a rate of return that is less than that of a traditional certificate of deposit or debt instrument of a comparable maturity. The return on a market linked CD can be calculated using several different methods, which is determined by the issuing financial institution.
With some market index CDs, you may earn only a percentage of the upside or downside of the index, this is referred to as the participation rate. A CD’s participation rate can be more or less that 100 percent. As an example, a market linked CD tied to commodity prices may have a participation rate of 80%. This means the CD return will be based, at least to some extent, on 80% of the return of the underlying commodity index. If the commodity index increases 10%, the CD return will be 8%.
There are at least two big risks associated with these bank CDs. The account holder may have an opportunity cost since the gains that can be obtained on these types of CDs are often limited by contract and can, of course, be zero. If the market based return with the CD ends up being less than could have been earned in a traditional fixed rate CD, there is an opportunity loss since that investor would have been better off with conventional interest bearing bank CD with a similar maturity.
In addition, the potential return of certain market linked CDs may be limited by a predetermined maximum return, a participation rate of less than 100% or other structure specific features.
With a market linked CD there is the possibility of earning zero interest or a minimum floor rate determined by the issuing bank. In this case, you only get the base rate of return the financial institution offered and it could very well end up being less than a more competitive, traditional CD. On the other side, if the market that the CD is linked to performs well, the CD account holder could end up with a higher profit than would have earned with a traditional bank CD.
Market linked bank CDs may fit in with certain an investor’s portfolio by providing diversification into different markets with some level of security. Market Linked CDs provide potential benefits beyond that of conventional CDs, as well as risks due to their distinctive market based return component.