Hitch your CDs to a bucking stock market?

They're touted as "can't lose" investments— but that's about the best that can be said of them.

By Dennis Murray
Senior Editor

In light of the stock market's recent jitters, you may well be getting nervous. Even if your ship still appears to be coming in, could it turn out to be the Titanic?

One way to temper your risk is by owning index funds, as the previous article explains. But doing so doesn't guarantee you won't lose money. For insurance like that—and a stake in stocks—you'd need something called "market linked" or "index linked" certificates of deposit.

What sets these CDs apart from traditional ones is that they let you tie your fortunes to a stock market index. And unlike index funds, they don't risk your principal. If the index the CD is linked to does well, you share in the gains; if it declines, you still get back your initial deposit.

Returns for market-linked CDs are usually keyed to the Standard & Poor's 500 Stock Index, but some are pegged to the Nasdaq, Japan's Nikkei stock market index, or the Chicago Board Options Exchange Internet index. Banks sell them directly to investors or through a brokerage; either way, you pay no commissions.

"Market-linked CDs have been increasing in popularity for three years, with tremendous growth during 1999," says Scott Snyder, investment manager with FISN, a Washington, DC, brokerage that specializes in certificates of deposit. The concept isn't new, however. These CDs first appeared in 1987, but when Black Monday hit later that year and investors' faith in the stock market was severely shaken, market-linked CDs quietly went away.

Now, understandably, banks are dusting off the concept. Some investors are nervous enough to want the security these CDs offer but still bullish enough to put at least one foot in the market. Market-linked CDs sound like a way to cash in while playing it safe.

So should you buy one? Probably not.

First, owning one of these CDs is more like dipping a toe, not a whole foot, in the market. While they'll give you a taste of any stock market gains, your return will likely be less—perhaps much less—than the market's.

Then there's the problem of figuring out your return. Banks term the rate you'll get the "participation rate" or "participation factor." They'd like you to think that participation rates are straightforward and easy to understand. If only that were true.

Although some market-linked CDs do move in step with the indexes they follow and reward you accordingly, most don't. For instance, annual returns are sometimes based on an average of how well the indexes do from month to month. So say the index is flat for 11 months, then soars 24 percent in month 12. You'll earn 2 percent for the year (24 divided by 12)—not 24 percent.

Other banks use an average based on a series of market closings in the last months of the CD's term. Some even calculate your fortunes based on a single day's return. "This is what I don't like about these products," says Robert M. Doran, a financial planner in West Milford, NJ. "How well you do becomes an issue of timing, which shouldn't be a factor with a fixed-income investment. Your returns could depend too heavily on when you purchase it."

Speaking of timing, these CDs are the wrong choice if you'll need your money soon. They mature in three to 10 years, and if you sell sooner, you'll likely pay a steep penalty for early withdrawal—as high as 30 percent of your initial investment. Also, some issuers take away all of your accrued earnings.

Another negative is that most market-linked CDs are callable. This means the bank can cancel the deal at any of several predetermined intervals spelled out in your contract. So if the market is white-hot, there's a good chance that the bank will return your initial investment plus a minimum rate it had guaranteed you. These guaranteed rates are often attractive, but they generally don't exceed what you'd earn if the CD were still linked to the stock market.

Thorny tax issues also arise. Your gains get taxed as ordinary income, not as long-term capital gains. For certain high-earning doctors, this could mean paying 39.6 percent tax on those CD earnings, rather than 20 percent. Why? According to Thomas M. Coan, FISN's founder and president, market-linked CDs must be treated as if they're accruing income each year, even though the earnings aren't realized until maturity. That "phantom income" has to be reported based on what a fixed-rate CD of an equal maturity would pay. However, Coan says taxes on gains are deferred if market-linked CDs are held in a pension or IRA account.

The bottom line, though, is that if you've got money you can't afford to lose, you're probably better off buying a traditional CD. Invest for five years, and you can currently get around 6 percent annually. With a market-linked CD, you may earn zip. If you want returns that more closely reflect market gains, purchase an index mutual fund. "If you plan to stay in a CD for five or 10 years, I think you'll do much better putting your money into a fund that tracks the same index the CD would have, especially when you consider the tax angle," Doran says.

Coan doesn't pull punches, either. "People who pride themselves on picking their own stocks or having a hotshot money manager do it for them aren't going to buy market-linked CDs," he says. "We sell them to conservative types, many of whom don't own a single stock mutual fund." He adds, however, that a few of FISN's clients are doctors who have a fiduciary responsibility for investing their employees' pension monies and don't want to expose themselves to any potential liability for mismanaging the funds.

Dennis Murray. Hitch your CDs to a bucking stock market?.

Medical Economics

2000;6:82.