Investing 101: Market-Linked CDs

By on February 25, 2014

Investors seeking to limit risk and hedge against inflation are snapping up a product that has not attracted much attention in recent years: market-indexed CDs.

A market-linked CD (MLCD), also referred to as an equity-linked CD, market-indexed CD or simply indexed CD, is a specific type of certificate of deposit (CD) that is linked to the performance of one or more securities or market indexes, like the S&P 500, NYSE composite or NASDAQ. These products pay a guaranteed return with the possibility of a higher return based on the performance of the stock market.

What is a Market-Linked Certificate of Deposit (CD)

When you purchase a CD, you commit to deposit a fixed sum of money for a fixed period of time — six months, one year, five years, or more — in exchange, the issuing financial institution pays you interest, typically at regular intervals. When you are ready to redeem or cash in your CD once it matures, you receive the money you originally invested plus any accrued interest.

Market-linked CDs are like traditional fixed-rate CDs but instead of a fixed interest rate offered by your local bank, the rate of return is tied to a major market index like the Dow or S&P 500. These products invest in more than one index or security and other diversify assets. By investing in more than market sector investors can reduce the risk that of losing money.

Typically, these CDs are insurance or backed by the Federal Deposit Insurance Corporation (FDIC), so your principal investment is protected from a total loss. Additionally, it is set up so if the benchmark (or index) falls by the maturity date, you still get your principal back.

How Market-Linked CDs Determine Returns

There are several ways to calculate the return on a market-linked CD, which is determined by the issuing financial institution. The two most common ways a market-linked CDs return is calculated are:

  1. Point-to-point: This is the simplest method which begins with starting value of the index when the CD is issued. The ending point is the value of that same index just before the CDs date of maturity. The return on the market-linked CD is the difference, or a percentage of the difference depending on the participation rate.
  2. Averages: Rather than calculating the return based on the initial and maturity date values of the index, this calculation monitors the values of the index along several dates, which are averaged.

Terms to Know Before Buying a Market-Linked CD

  • Participation Rate: This is the percentage at which the return of a market-linked CD will correspond to the performance of the index to which it is tied. For example, an index sees a 25 percent gain, but the CD linked to it has a participation rate of 80 percent. This means the CD will produce a return of 20 percent, or 80 percent of 25 percent.
  • Interest Cap: There is usually a cap on how much interest an investor can earn; this protects financial institutions from huge pay outs, so if the market index grows by 100% you may not receive exactly a 100% return.
  • Call Options: Some market-linked CDs have a call option which give the issuing financial institution the right to (buy) call back the CD before it matures. The call price determines how much interest the investor earns, which may be less than if the CD were held longer or until maturity.

Advantages of Market Linked CDs

When an investor purchases an array of stocks, bonds and mutual funds, there is nothing protecting them from losing every penny should the market take a dive, however, most issuers of market-linked CDs offer principal protection. There are many advantages to market-linked CDs, here are a few more merits to pique your interest:

  • FDIC Insurance: The principal investment is insured to a maximum of $250,000, per insured bank, and up to $100,000 thereafter, just like any other savings accounts or CDs.
  • Guaranteed Principals: Get your principal back as long as you do not withdraw money from the account before the maturity date
  • Contained Liquidity Limits Panic: Avoid making snap decisions or scrambling to buy or sell stocks when the market takes a sudden dive or jump.

Tax Implications of Market-Linked CDs

Market-linked CDs have special tax implications which differ from traditional CDs. Usually, index-based investment income is taxed according to the rate for capital gains, up to 15 percent.

Market-linked CD returns are considered interest income and taxed at the holder’s ordinary income rate. There are options for holding a market-linked CD in a tax-deferred account, such as an individual retirement account (IRA), which can help the investor to avoid paying taxes on earnings.

Potential Drawbacks to Consider with a Financial Advisor

There are some drawbacks to investing in market-linked CDs, which may be avoided with the help of a trusted financial professional.

Early Withdrawal Penalties

Even though the principal investment is guaranteed up to the date of maturity, this is not the case for early withdrawals. There are typically significant withdrawal penalties if you tap into the account before maturity.

No Dividend Reinvestment or Distribution

When investors buy stocks or securities, they earn returns from the dividends that the company pays out to shareholders – these may be counted as income or reinvested to grow the portfolio. Market-linked CDs do not benefit from these distributions of profits and the chance to compound the returns.

When is a Market-Linked CD the Right Investment for You

Market-link Certificates of Deposit are best suited for buy-and-hold investors who do not require a high level of liquidity and wish to implement an asset allocation strategy with a diversified portfolio. These CDs may also be highly beneficial for those who do not need the cash until the date of maturity (to avoid early withdrawal penalties) and wish to house the CD in a tax sheltered account (to avoid the unfavorable tax liabilities).

Before investing in market-linked CDs, be sure to meet with a trusted financial advisor or broker to discuss the merits various market-linked CDs, any tax implications and how these accounts can benefit and diversify your investment portfolio.

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About Terri A. Kamoto

Senior writer for FSN - Terri is a former financial analyst dedicated to making personal finances, budgeting, investment and insurance advice accessible, up to date and easy to understand. It is hard to find professional advice written in a language someone without a financial background can understand. Terri helps companies synthesize industry lingo and expertise into clear and informative content which builds smarter, financially successful individuals. You can find Terri on !

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