Equity-Linked CDs: A Guide to Investing in Certificates of Deposit Linked to Stock Index Performance

Equity-Linked CDs are financial products that combine the features of both Certificates of Deposit (CDs) and stock indices. These CDs are FDIC-insured and offer investors the opportunity to earn returns based on the performance of a stock index, usually the S&P 500 Composite Stock Price Index, over a specified term. The interest rate is linked to the index, and investors can earn a potentially higher rate of return than traditional CDs if the stock index performs well. However, there are potential risks and considerations to keep in mind before investing in Equity-Linked CDs.

Equity-Linked CDs usually have a term of five years, although this can vary between financial institutions. The interest rate on the CD is determined by the performance of the stock index, which is measured at the end of the term. The interest rate may be calculated by taking the average of the closing prices of the index over a specific period, such as every six months. The participation rate determines how much of the index's increase will be used to compute the interest calculation. For example, if the participation rate is 70% and the index goes up by 10%, the investor will earn a return of 7%.

Some Equity-Linked CDs also set a cap on the return that can be earned, regardless of how well the relevant stock index performs. This means that if the stock index performs well, the investor's return may be limited by the cap. For example, if the cap is set at 10% and the index goes up by 20%, the investor's return will be capped at 10%.

Risks Associated with Equity-Linked CDs

While Equity-Linked CDs offer the potential for higher returns than traditional CDs, they also carry risks that investors should be aware of. One of the most significant risks associated with Equity-Linked CDs is liquidity risk. Investors typically have limited opportunities to redeem their Equity-Linked CDs before maturity, and financial institutions do not guarantee the existence of a secondary market. Many Equity-Linked CDs do not allow early withdrawal without the consent of the financial institution, and investors who need to withdraw their investment before maturity may incur withdrawal penalties and lose any interest that would accrue in a regular CD with the same terms.

Market risk is another consideration to keep in mind when investing in Equity-Linked CDs. If the CD is sold before maturity, it may be worth less than its purchase amount or face value, subject to a number of variables such as stock market volatility and changes to the components of the linked index. Additionally, there is no guarantee of principal return unless the investment is held to maturity.

Another potential risk is call risk, which occurs when an Equity-Linked CD is callable. If this happens, the investor's return may be less than the yield for which the CD would have earned if it had been held to maturity, and the investor may not be able to reinvest their funds at the same rate as the original CD.

It is also essential to consider the tax implications of investing in Equity-Linked CDs. These products may be treated differently than traditional CDs for tax purposes, and investors should carefully review the disclosures concerning the reporting of interest income and consult a tax adviser if necessary.

FDIC Insurance and Equity-Linked CDs

In general, Equity-Linked CDs are insured by the FDIC up to the amount permitted by law. FDIC insurance covers the principal and any guaranteed interest on the Equity-Linked CDs. Investors should carefully read the issuer's disclosure about how the FDIC limits apply in specific circumstances and review the FDIC's brochure entitled "Your Insured Deposits."

To sum up, equity-linked CDs can be an attractive investment option for some investors, as they offer potential for higher returns and protection against market downturns. However, investors should be aware of the risks associated with these products, including liquidity risk, market risk, call risk, and the potential for a cap on gains. Before investing in equity-linked CDs, investors should carefully review the terms and conditions of the product and consult with a financial advisor or tax professional to determine if it is a suitable investment for their portfolio.

Author: Brian McKay
April 11th, 2023