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.