The Positives & Negatives of Index-Linked Certificates of Deposit
Index-linked certificates of deposit are savings accounts that do not pay a fixed interest rate. Instead, returns on these CDs are based on the performance of an index such as the Standard and Poor's 500. These CDs appeal to investors when interest rates are low, but there are both pros and cons to buying indexed CDs.
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Safety
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Banks issue indexed CDs and therefore these instruments are protected by the Federal Deposit Insurance Corporation. As with other CDs, indexed CDs cannot lose value, as the index has no impact on the value of the principal. The coverage extends to $250,000 per account owner, per bank. You could buy several indexed CDs from different banks and enjoy up to $250,000 of coverage on each CD even if you hold all the accounts in the same brokerage account.
However, FDIC coverage usually only extends to the principal and not the returns since the returns are based on the performance of securities. When you buy a regular CD, the principal and interest are protected.
Returns
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Indexed CDs are usually tied to indexes containing stocks. Historically, stocks have offered much greater growth potential than interest-bearing accounts. Therefore, you can enjoy the benefits of market upturns without having to risk your principal by investing directly in stocks. However, you only make money on an indexed CD if the index performs well. Generally, the CD issuer makes a payout based on the index once a year, but some issuers only make a payout at the end of the CD term. If the value of the index on the day you buy the CD exceeds the value of the index on the payout date, you do not get a payout. You could hold an indexed CD for five years without earning a penny.
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Participation Rate
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Some indexed CD contracts include clauses that limit your returns in the event that the index performs well. Your "participation" rate determines the extent of your payout during a market upturn. If you have a participation rate of 80 percent, that means you receive a payout equal to 80 percent of the amount that the index linked to your CD rose. If you invested $10,000 and the index rose 10 percent, you would only receive a payout of $800. However, rules on returns vary, so shop around for an indexed CD that does not severely restrict your returns. Even where participation caps apply, potential returns often exceed the returns available on fixed-rate instruments.
Other Considerations
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Indexed CDs have longer term times than regular CDs, which means you do not have to spend as much time actively managing your investment. During market downturns you do not have to reposition your investment as you would if you owned stocks or bonds because your indexed CD cannot lose value. However, indexed CDs are illiquid and if you need to access funds prior to maturity you must pay a penalty that often exceeds 10 percent of the account value. Additionally, you cannot make partial withdrawals, so if you access funds you must close the CD and pay the penalty on the entire amount of the CD.
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