A Case Study On An Index Linked CD

An index linked CD, aka market linked CD or equity linked CD, is a bank CD with an interest crediting formula tied to a market index. The main attraction of an index linked CD is that the value of the CD can go up with the market index but it can’t go down. The principal of the index linked CD is guaranteed both by the bank and by the FDIC.

The no-loss guarantee usually comes at the price of capping the upside. The chart below shows what a market linked CD will do versus a straight-up ETF that tracks the index. The horizontal axis is the average annual (not cumulative) return of the index.

What if you are conservative and you are willing to give up some upside for downside protection? Can you achieve the same result through more conventional investments? I’m interested in the answer so I did this case study.

I went into a branch of a major bank and asked if they sell index linked CDs. They do, but they wouldn’t just give me a brochure. The rep there said I must make an appointment with one specific person who’s authorized to sell the product. I did that. After a brief meeting, he gave me the disclosure document, which is similar to the prospectus for mutual funds.

The bank offers several different index linked CDs tied to different indexes ranging from the stock market to commodities and currencies. I picked the simplest one for this case study.

This particular index linked CD is a five-year CD linked to the Rogers International Commodity Index – Excess Return. Excess Return means Total Return minus 3-month T-Bill returns. The index return is calculated point-to-point, from the date the five-year term begins to when it ends. No interest will be paid during the five years. At the end of the five years, the investor receives 100% of the index return during those five years, subject to a cap of 60% cumulative. If the index return is negative, the investor gets the principal back without interest.

People who don’t like index linked CDs typically argue that one can synthesize it by investing part of the money in a plain vanilla CD that pays interest and the rest in a mutual fund or ETF that tracks the index.

It’s actually not that simple.

If you try to match the downside protection by putting a large percentage of the money in a plain vanilla CD, you won’t be able to match the upside potential of an index linked CD. If you try to match the upside potential, you leave the downside exposed.

The chart below compares the index linked CD with a combination of 75% in a plain vanilla 5-year CD plus 25% in a commodity index ETF. The plain vanilla 5-year CD is assumed to earn 3.5% APY, which is about the highest one can get at present.

The 75% plain vanilla CD plus 25% ETF combo will not lose money as long as the average return of the index for the next five years is above -13% a year (50% cumulative loss). Between -13% a year and +4.5% a year, the 75/25 combo beats the index linked CD. If the index return goes above 4.5% a year, however, the index linked CD starts to lead. The 75/25 combo can’t catch up with it unless the index return is more than 24% a year (190% cumulative gain over five years).

What if you put less in a plain vanilla CD and more in the ETF? Then you will start losing the downside protection. Look at this other chart:

If you put 50% in a plain vanilla CD and 50% in an index tracking ETF, that combo will lose money if the index return is less than -3% a year over five years (15% cumulative loss on the index). A 50% cumulative loss over five years is bad luck; a 15% cumulative loss on the index is quite conceivable. Between -3% a year and +4.5% a year, the 50/50 combo beats the index linked CD. If the index return goes above 4.5% a year, however, the index linked CD starts to lead unless the index return is more than 16% a year (110% cumulative gain over five years).

The conventional investments don’t quite cut it in terms of matching the risk/return profile of an index linked CD. In order to match it, you will need to use conventional CDs and call options. However, there are no easy ways for a retail investor to buy 5-year call options on a commodity index. The bank that sells the index linked CDs essentially buys the options on the capital market and packages them with a markup to retail investors.

What are some of the risks of investing in this index linked CD? The disclosure documents list many risk factors. Here are a few of them:

No early withdrawal. It’s a firm commitment for the full term. No early withdrawal is allowed except due to death of the investor. There might be a secondary market for these but I wouldn’t count on it. I would treat it as a solid lock-up. If I invest in a commodities ETF, it would be buy-and-hold anyway.

No interest if the bank is taken over by FDIC. Because the interest is only credited at the the end of the term, if the bank fails before the term is up, FDIC only guarantees the principal. This particular bank is already deemed too big to fail. I’m not too worried.

Negative cash flow in taxable account. If someone buys these in a taxable account (I won’t), he/she must accrue some projected interest along the way and pay tax on it. It’s all squared up in the final year when the CD actually pays interest. If it turns out you paid too much tax because the projected interest exceeded the actual interest, you will get back the excess tax paid in the final year. Not a big deal in my view. Just something to be aware of. One can easily avoid this hassle of figuring out taxes by buying the CD in an IRA.

Are index linked CDs good or bad? I used to think they are all bad. That’s also what I read and heard in the mainstream media. After I studied the details, I don’t think they are so bad that they must be dismissed out of hand. For an asset class that is known to be high risk, such as commodities, an index linked CD can be effective in managing risk. It retains more upside than a comparable allocation in conventional investments.

Whether an index linked CD is good or bad really depends on its terms and on how the investor uses it. I find this particular index linked CD quite acceptable. I may end up putting some money in it. However, some of the other index linked CDs offered by the same bank are not as good because they use a six-month averaging formula when they calculate the index return. If someone approaches index linked CDs as  replacement for income-producing CDs, that’s really the wrong angle. You have to treat these as alternatives to long-term investments.

I remain skeptical of index linked CDs’ cousin Indexed Universal Life Insurance (IUL), because an IUL comes with the baggage of life insurance, which one may or may not need. Even if one needs life insurance, the cost of such life insurance in an IUL may or may not be competitive.

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  1. Chuck says

    The guaranteed return is nominal, so after 5 years you stand to have lost maybe 15% of your principal to inflation.

    It’s true that you can’t buy a 5-year call over the counter, but you can get LEAPS up to 2 years. What if you buy the conventional CD and invest the interest payments in the longest call available? (It’s starting to look like a lot of work, now!) My guess is that over the long term, you could come close to matching the returns of the equity-linked CD but there are basically two factors working against each other:

    On the “pro” side, if you do it all yourself, you get to keep the profit that the bank would have taken.

    On the “con” side, the bank can make larger transactions (especially commodity-related options!) with lower overhead than you can, so even when they take out their profit, there may still be more left for the customer.

    However, it’s good to point out that these things are not magic, and they’re certainly not free money.

  2. Harry Sit says

    Thank you Chuck. If the commodities don’t do well, the CD/ETF combo also stands to lose to inflation. So that’s a wash.

    Buying LEAPS would be an idea, but on a commodities index? Do you know one so I can add as an alternative to this case study? If it were the S&P index, it would probably be viable, at least worth looking into. I just haven’t seen options on a commodities index available to retail investors.

  3. Chuck says

    Regarding inflation, I wasn’t meaning to compare the linked CD to roll-your-own. I was just referring to how silly it is for any product to advertise “you can’t lose money” by maintaining nominal value for 5 years.

    Regarding options — it seems like you can only get oil and precious metals options. Bleh:


    So if oil or gold or silver was what you wanted to speculate on, there’s a vehicle to do it. Except USO and its siblings are such dogs you couldn’t pay me to get involved with them.

  4. Harry Sit says

    Anthony – Yes, it is. It’s actually the Costless Collar: Long 100 Shares; Sell 1 OTM LEAPS Call; Buy 1 ATM LEAPS Put.

    From the CBOE commodities funds options link posted by Chuck, the closest match to a diversified commodities index tracking fund would be the Powershares DB Commodity Index Tracking Fund (ticker DBC) or iShares GSCI Commodity-Indexed Trust (ticker GSG). However, one can’t execute the costless collar strategy at the current option prices.

    DBC sells at about $25 per share right now. A January 2012 put at $25 costs $360 per contract. There is no out-of-the-money January 2012 call that the investor can sell for more than $360 per contract. GSG options only go out to October 2010 but it’s the same story. No out-of-the-money call sells for more than the cost for a at-the-money put.

    So the index linked CD is actually more cost effective than trading options yourself. But we also have to recognize that it’s an European option whereas the traded options are American options.

  5. Frank says

    I am doing research on an Index UL vs an Index CD. The one thing bad I keep hearing about the IUL is the cost of insurance. Isn’t this cost only around 1.25% per year? Don’t my IRA fees cost at least that much? I have recently seen a 60 minute video about hidden 401k fees and how atrocious these fees are, yet we can’t see them. 1.25% does not seem that expensive, especially, when that money covers a death benefit that is many times more than my accumulated cash value in case something does happen to me.

    Another thing is doesn’t the money out of the IUL come tax free as a loan against your cash value in the policy? I think not paying 30-50%(I live in CA and our state taxes are not cheap) out of my IRA or 401k would be more expensive than taking the money out tax free.

    Can’t you also access the cash in the policy whenever you want without any penalties?

    I’m just trying to figure out all of the downside before I purchase and to see if I’m missing something.

    Any comments would be greatly appreciated.


  6. Harry Sit says

    Frank – You are missing a lot; I don’t know where to start. If you are real prospective customer, not an insurance agent pretending to be one, pay attention.

    The IRA fees can be as small as 0.25%, that’s 1/5th of 1.25%. It’s also an investment cost, not a fee on top of investments. An IUL has both cost of insurance and investment cost. The cost of insurance levied in an IUL can be 3-5 times higher than the true competitive cost of insurance. The up to 5% premium tax is a total waste that benefits nobody except the state government. You get a tax deduction when you contribute to a 401k. The 30-50% tax you are talking about is a wash against the tax deduction you got when you contributed. No honest insurance agent will recommend that you don’t contribute to a 401k but buy an IUL.

  7. Frank says


    How is a tax I don’t pay now of a few thousand dollars a wash to a tax I will pay when my money grows 3 or 4 times the original investment over 30 years? I know there is no estate tax this year, but it’s going to go to 55% over $1mm next year?!? How do you deal with that when you pass this money to your heirs?

    How about our deficit? I’ve doing some research on that and it’s astounding. Did you see the article, “Bernanke: America Facing Financial ‘Armageddon'”. That is some scary stuff.

    How do you find which IRA has fees that are only .25%? My biggest concern is that if nothing is done, by 2020, our deficit could be as high as 9% of GDP. I just don’t like all of this uncertainty and with the IUL there is safety.

    I have been watching a lot of videos on youtube and the fact that you can’t lose your principle(can the IRA guarantee that?), you can have gains in double digits(isn’t an 8 or 9% mutual fund over 20 or 30 years a good return?), you lock in your gains every year, your money comes out tax free(can you really tell me with our deficit that you don’t think taxes are going up? Oh, and my social security statement used to say in 2017, more benefits were going to be sent out in this year than money taken in…..it now says 2016.) and it is passed to heirs tax free.

    What if you work your ass off, get a couple of million dollars in your IRA, you die, can you tell me how that money would be passed to my heirs?

    Sorry TFB, it’s been 2 weeks since I wrote that and i’m becoming convinced more and more each day that uncertainty is not something i want to bank my life’s savings on.

    And no, i’m not an insurance agent. What i am doing right now is listing the 401k vs IUL on paper, and I can tell you that the 401k in the long run may beat it, but we won’t know for 30 years. I’ll take some guarantees, tax free money in retirement and maybe when you are done paying your taxes(which we have NO IDEA what they will be), I’ll buy you lunch or dinner with my excess reserves!!

  8. Frank says

    Hey TFB, did you see any of the articles on Steinbrenner these last couple of weeks? They said that if there was a 55% estate tax this year, he would have owed over $600,000,000 in taxes?!? He paid $10mm for the team in 1973. I’d rather pay tax
    on $10,000,000, not $1,200,000,000.

    Let’s see, $5mm vs $600mm

    HMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMMM! This decision is getting easier and easier, but i’m not going to pull the trigger for a little while longer.

    So if you have anything to add, i’m listening and if it’s good advice, i’m all ears.

  9. Frank says

    This is the video I watched about locking in the gains. I can’t believe they do this, but this seems too good to be true.

    So when the market goes up, i lock in my money, and when it goes down, i don’t lose what i already earned; it just stays where it was until the market decides to wake up again, is that correct TFB?

  10. Frank says


    I just read this:

    “You will pay back every dollar you saved in tax on twenty-five years of contributions during the first four and a half years of retirement(only at a 33% tax bracket, which won’t exist for me with the money I make). If you live twenty-two years after retiring, you’ll potentially pay back five times more in taxes during the distribution phase than you saved in taxes during the contribution phase.” OUCH.

    That is in response to you saying that the tax i save in the contributing phase washes out the distribution phase. it is starting to sound like you are a salesman for 401k and IRA.

    I found another good article in the LA times talking about, let’s admit it, the 401k did not work.

  11. Frank says

    What is also crazy is your article:


    I agree 100% with what is written here so why is the Index UL so bad? I found a chart that shows with your gains being locked in every year, my money during the “Lost Decade” would have been up over 80% (S&P 500) compared to it being in the market in an S&P 500 index.

    I just don’t have 10’s of hours a week to be researching my portfolio and it seems that i won’t have to. Yes, there is a cost of insurance and other expenses, but over time those go away and I don’t have to worry about it.

  12. Harry Sit says

    Come on Frank. I already told you it’s your money and do whatever you want with it. If you think you found the perfect solution, go ahead. Why are you spamming all of us again and again? Estate tax won’t be an issue for us because we don’t own a baseball team. Maybe it is for you. In that case, stop watching youtube and call your attorney.

    As to why the tax paid years down the road is a wash to tax not paid today, it’s 2nd grade math. Search for Commutative Law of Multiplication.

  13. Frank says

    Which 2nd grade math? You sound like you are smart, so what is the formula I’m supposed to use? Time value of money?

    Unpredictability of taxes? Give me some date and/or fax and i’ll use it.

    How am I spamming when i’m responding to your article? I think i’m bringing up valid points, and your respons is, “search for Commutative Law of Multiplication” WTF is that.

    I’m trying to find real solutions and that is how you respond like we are 3rd graders trying to win an argument. I’m trying to get you to show me why your way is better and i’m not seeing it.

    How do you know Estate Tax won’t be an issue? It’s only $1mm next year. My own parents are worth over $2mm and they are middle class that has saved and invested properly over time. If I thought i could do what they have done, I would, but investing directly into the stock market is a little scary….especially, if i can get the same returns(maybe i lose the upside years), but guaranteed to not lose my money is something that is hard to argue against.

    My parents are in their mid 60’s and their estate could easily double 1 or 2 more times since family history has grand parents in early 90’s and late 80’s. I could be looking at an estate of $6mm and have no idea what the estate tax will be.

    It seems to me to make sense to get that money out of the taxable estate if I can, but i’m not an expert.

    If you have something viable to say, then say it, if not, i’ll meet you at the cat walk after school.

  14. Harry Sit says

    Okay, Okay, you refuse to search. I search it for you. Commutative Law of Multiplication says A * B = B * A. If you have $3,000 today, you can pay $1,000 in tax today and grow the rest $2,000 to $20,000. Or you can put the $3,000 in a 401k and let it grow to $30,000, pay $10,000 in tax and end up with the same $20,000. Yes, you will pay 10 times as much in tax, but if you end up with the same amount to spend, how does it matter?

    You are probably going to say tax rates will go up. Maybe so. That’s why there is Roth 401k.

    One more time: I’m not going to show you that my way is better. If you found a better way, go ahead. I’m not going to hold you back.

    And here’s another nugget for you. If you haven’t depleted the cash value of your life insurance through loans and withdrawals, the leftover is also subject to estate tax when you die, the same as money left in 401k or IRA. Merely buying life insurance is not going to get the money out the taxable estate. To get around the estate tax, you will have to set up a trust of some sort. That’s why I said call your attorney.

  15. David says

    @Frank–TFB is a pretty smart guy. He’s right on the Commutative Law of Multiplication.

    @TFB–your assumptions work as long as tax rates don’t change AND deduction amounts don’t change. I think if you change those, then your assumption of paying the same in tax is wrong, but not because the math is wrong. I think you’re banking on the idea that deduction amounts will never change and tax rates won’t change either, in a lot of your assumptions about traditional 401(k)s/IRAs. If they don’t change, then you’ll be right. If they do change, your suggestions now will be very expensive later. It won’t matter if you convert to a Roth later. You won’t escape the higher tax rates at that point, if they go up (or if deductions go down).

    RE: Life insurance–actually, the cost of insurance is the same for all life insurance policies because they all use the same mortality tables (well, mostly–unless someone is still use the 1980 CSO tables). So, when you purchase an annual renewable term life policy, you’ll pay the same as when you buy a whole life policy.

    The reason the premiums are different is because the insurer uses level term funding (they collect excess premium and invest it to hold down future out of pocket costs) for the whole life. But, actuarially, the term policy and the whole life are the same. Actually, the whole life premiums will be less, IF you do a true apples to apples comparison and buy term life out to the maximum insurable age (well, technically, you’d have to buy it out to age 100 for a true apples to apples cost comparison) since the level term funding reduces the policyholder’s out of pocket cost. Now, for UL policies, you just have an annual renewable policy with a cash account. You can make them really expensive by paying under the target premium or really cheap by paying over the target premium up to the MEC guideline.

    People who are accumulating cash in those IULs simply reduce the costs of insurance by selecting the level death benefit option and then going back every once in a while to reduce the death benefit to the IRS minimums allowed under either the CVAT or Guideline Single Premium Test. The cost of insurance actually goes down over time, not up, since the net amount at risk decreases (even though the cost per 1,000 of death benefit is increasing). I was confused about that for a long time until I spoke with an actuary.

    What this means: after about 20 years, your total expenses normally work out to be right around 1 percent of the total cash value for most companies, unless you find a company that gets really crazy with policy fees. The longer you hold it, the lower the total costs are. So, at year 20, your expenses might be 0.847 percent, at year 30 they are 0.422 percent, at year 40, they are 0.233, etc.

    RE: IRA costs–I think when you compare an IRA to an IUL, you should probably also buy some term insurance and then compare the costs as a percentage of your investment. Because, this basically goes back to “buy term and invest the difference.”

    There’s two ways to do this: Buy a UL (which is, as a matter of fact, “buy term and invest the difference”) or buy a level term policy and invest outside of the insurance policy. I think to get an accurate picture of the costs, you need to be doing the same thing as what you are doing with the UL. You seem to be throwing away the cost of a life insurance policy and saying that it’s cheaper to just use an IRA with low cost investments. Well, yes, of course it’s cheaper. 🙂

  16. Steve Wasylkowski says

    As mentioned above, not all Market-Linked CD’s are the same.

    Some pay interest annually. Some are linked to a basket of stocks so you have to figure out the average return of the basket.

    Some use an auto-cap feature where you receive the cap rate for that security as long as the price is even or above it’s initial price.

    Its not easy to use a formula such as the one above for comparison purposes.

    All in all they are a good fit for a portion of your safe money especially if you are retired. Low interest rates on standard CD’s also adds to the alure.

  17. Dale says

    I am wondering if any of the structured cd’s look attractive in the current market. Does anyone think the commodities linked ones are still preferable? I am speaking as a long term, conservative cd purchaser with no risk tolerance.

  18. Harry says

    Dale – As this article showed, you can’t generalize. It all depends on the terms of a specific CD. If you have the document for one you are interested in, I can do an updated case study. In general, you want to see these terms:
    – Linked to an index with low dividend yield (because you don’t get the dividends anyway)
    – Use a point-to-point formula with no averaging nor annual caps

    A CD linked to a commodities index would be a good candidate because commodities don’t pay dividends and because commodities are expensive to invest in, but that’s only a starting point. Whether the CD is actually a good buy will depend on the other terms.

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