What is an index-linked Certificate of Deposit (CD)?
An index-linked CD is a deposit obligation of the issuing bank and is often sold through bank branches and by both affiliated and unaffiliated brokers. Index-linked CDs provide the investor the ability to participate in the appreciation, if any, of a particular index, during the term of the CD. Index-linked CDs may have complicated payout structures and may not be suitable or appropriate for all investors. Investors should carefully review the CD terms and investment risk considerations detailed in the relevant offering documents and disclosure statements.
What are index-linked Certificates of Deposit (CDs) also known as?
Common names for index-linked CDs include market-linked CDs, equity-linked CDs, and market participation CDs.
How do I earn interest on an index-linked Certificate of Deposit (CD)?
The interest on an index-linked CD is tied to an index selected by the bank, such as the S&P 500, LIBOR or the Russell 2000. Depending upon how the CD is structured, the investor may earn interest if the index changes. Some CDs pay interest based on an increase in an index; some pay interest based on a decrease in an index. Some CDs pay interest if an index stays within a certain range, but they pay no interest if the index moves out of that range. In addition, some CDs average changes in the index quarterly or annually during the term of the CD. This may produce a different result than a formula that focuses upon index results as of specific dates (e.g., 3/31 or 12/31).
The interest on the CD may be subject to a cap or a participation rate. A participation rate determines how much of the index’s change will be used to compute the interest. For example, if the index goes up 10% and the participation rate is 80%, the investor will receive 8% interest over the term of the CD. If the index goes down, the investor could earn zero percent interest over the term of the CD. Customers should look at APY disclosures when comparing products.
Is 100% of my index-linked Certificate of Deposit (CD) protected?
Subject to early withdrawal penalties, if any, and FDIC insurance limits, index-linked CDs are 100% principal protected. However, if interest payments on the CD are contingent on changes in the index that are measured on a specified date, the interest is not protected until that date.
Will I receive periodic interest payments on my index-linked Certificate of Deposit (CD)? Are these payments taxable?
Unlike traditional CDs, periodic interest payments are typically not paid. However, investors are required to include a “comparable yield” in their gross income each year for federal income tax purposes even though no cash payments may be made to the investor on these CDs until maturity. By purchasing an index-linked CD in an IRA or other tax-advantaged account, an investor may avoid reporting comparable yield income each year on their taxes.
Are index-linked Certificates of Deposit (CDs) FDIC insured?
The principal amount of an Index-linked CD is insured by the FDIC up to the maximum applicable deposit insurance coverage. However, any contingent interest owed to the investor is the obligation of the issuing bank and is not insured by the FDIC. In order to determine the amount of FDIC insurance coverage, the investor must include the principal amount of the index-linked CD, together with all other deposits maintained by the investor at the bank. The current maximum insurance coverage of $250,000 is temporary and is set to expire on December 31, 2013. On January 1, 2014, the standard insurance amount is scheduled to return to $100,000 per depositor for all account categories except IRAs and certain other retirement accounts, which will remain at $250,000. Because many of these CDs do not mature for several years, it is important to consider that FDIC insurance coverage may revert back as of 2014 to the $100,000 limit. For any amount over the maximum applicable deposit insurance coverage, the investor is subject to the direct credit risk of the issuing bank.
Can I redeem my index-linked Certificate of Deposit (CD) before its maturity date?
There may be no active secondary market for an index-linked CD and penalties (including loss of principal) can be significant, if early redemption is available. Index-linked CDs are not designed to be a short-term investment, so an investor should be in a position to hold the index-linked CD to maturity.