Market Linked Certificates of Deposit

Market linked certificates of deposit are a partially speculative play on the stock market, with all the security and safety of a FDIC-insured account. Market linked CDs do give investors the opportunity to hedge against rising stock prices and profit through robust returns, and also limited downside risk in that your principle cannot be lost.

How They Work
Generally, market linked certificates of deposit allow you to take advantage of any particular index you wish including commodities, stock indexes, and even the return of inflation through the Consumer Price Index. Your investment dollars are used to purchase the CD, which the investment company then invests in derivatives to achieve your expected return.

As a rule of thumb, most market linked CDs will offer roughly 90% of the upside, and 0% of the downside of the particular index you choose to track. That is to say that if you attached the market linked certificate of deposit to the S&P500, and it were to rise 15%, then you would receive 90% of that return, or 13.5%.

Alternatively, your principle is entirely protected. Thus, if the market were to decline by 15%, you would receive (at the end of the term) your investment yield on the CD, minus the loss. If this figure comes out to be negative, then you would receive your principle back in return, thus creating no losses on your purchase. However, you would have essentially lent your money away for free for the length of the product.

The benefit is clearly evident: by purchasing a market indexed CD you can have most everything in the upside in stocks, but stand to lose only what you would receive in interest. Thus, if the markets were to rise by 50% in 5 years, you get a 45% return. If they fall by 50%, then you get your money back. Sounds like a pretty good deal, huh?

Market Linked Downsides
There are a few downsides to market linked CDs, but most are restricted to the tax code.

The only downside that does not come as a result of taxation is your inability to sell your CD. Once locked in, your CD is invested and you will not be able to make a withdrawal until the product has matured. While some brokers do allow for early withdrawal, almost all come with penalties, many of which are much larger as a percentage of assets compared to traditional CDs.

In terms of taxation, MCLDs are considered to be a unique form of debt instrument. Thus, all returns, whether you have realized them or not, are taxed at the rate of your income taxation. This is a very important detail for any investor, and you should be sure to note that most MCLDs simply do not make good financial sense unless you can be sure that 1) the markets will rise (if you were sure, you’d just buy the index itself!) or 2) your MLCD will be held in a tax-advantaged retirement account.

Who Should Own Them
All things considered, market linked certificates of deposit would fit best in portfolios that were soon to be cashed for retirement, and should make up only a fraction of your total investment dollars. When thinking about how to reduce your net equity exposure, consider the MLCD as a way to get a guaranteed return of principle, but not a guaranteed return.

Such an investment means that you’ll be able to enjoy most of the benefits of investing in stock without all the risk. For many soon to be retirees, this product could be an absolute lifesaver!

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