Market-linked CD's

[RandyAdams1978]

The more I educate myself on bonds and bond mutual funds, the more jittery I'm getting. Talk of the bond bubble unnerves me. I've got a good chunk of change saved up for college expenses for my three children. I don't want to lose it. The wife wants to put it into a 5-year jumbo CD that earns 1.85 APY. I was trying to come up with some sort of stock/bond mix that would be safe. I looked at 529 possibilities. I looked at tax-free and tax advantaged funds. But the more I read the more the point is driven home that NOTHING invested in stocks OR bonds is 100% safe. I've always known that. I just never had this much money and short a time horizon before. I need this money starting in 4 years. To me, stocks and bonds are like gambling right now.

What's the Boglehead view of MLCD's? I like the downside protection. I don't really care about the limited upside. The biggest gamble I'm taking here is that my money might make less than the 1.85% I would get in the Jumbo CD. If I invest 100,000 in a jumbo CD, I get about $109,500 at the end of five years. I'm sure the MLCD would give less. But that's a loss I can live with. The other gamble is tax consequences. I need to investigate those more thoroughly. I've not been able to find current specifics from any bank online. Just some old PDF's. And the "Call Us Now" button.

Just curious as to what others thoughts/experiences with MLCD's might be.

[Default User BR]

What age are you? It seems like you're far too focused on potential drop in value. That should be controlled by overall stock/bond allocation. Also, erase the term "bond bubble" from your mind. Bond fund prices are by and large transparent. They can't really be in a bubble the way stocks or other assets can. Yes, a rise in interest rates would cause a drop in NAV, with a corresponding increase in yield.


Brian

[RandyAdams1978]

This is not a retirement fund. This is money earmarked for college. The goal is to not lose ANY of it. I'll need it starting in 4 years. Stocks and bonds --- in any mix --- do not offer guarantees of the principal.

I was just trying to find out if any members have experiences with market-linked CD's they would like to share. I'd be curious to hear their opinions/comments.

[LadyGeek]

First, take a look at the wiki and study the illustrative example: Market-linked CD

Would you be satisfied if you just walked away with the principal, as the value at maturity might be close to that. It's possible, why gamble?

Another point is that the FDIC insures principal only (prior to maturity), not principal + interest as with conventional CDs.

[RandyAdams1978]

Well, the worst I could do is still have my initial investment, less the taxes I would have paid annually. I don't know what to do, frankly. A 5-year jumbo CD is paying 1.85% ANY mix of stocks and bonds is too risky at this point, especially for my eldest child, who's only 4 years away from entering college. The youngest is 10 years away, so theres a little wiggle room there. Not much, but with the youngest there's at least SOME time to recover from a bad year or two. For the oldest... not so much.

[Leesbro63]

What about a PREPAID type 529 plan, like I have for my kids here in PA?

[RandyAdams1978]

Ohio's pre-paid plan was discontinued. In 2004, I believe.

[JamesSFO]

How about looking at the Vanguard recommended allocations for 529 plans https://personal.vanguard.com/us/content/Funds/Funds529AgeBasedJSP.jsp

Might give you a sense of possible asset allocations.

[livesoft]

.... ANY mix of stocks and bonds is too risky at this point, especially for my eldest child, who's only 4 years away from entering college.

Unless your child is going to graduate from college in 4 years, you will have more than 4 years before any investment is really needed. For the risk averse, I would suggest a combination of I-bonds from Treasury Direct and the VINC option in some 529 plans such as Ohio's CollegeAdvantage.com.

Also one can borrow from a 401(k) while waiting for any bond losses to recover if needed. One can even borrow from a 401(k) and use the proceeds to invest in a 529 plan. One person on the forum did this and it worked out really well for them.

Basically, there are lots of options before resorting to a market-linked CD. Nevertheless, if someone who had one could tell us how it worked out for them, it would be nice to read about it here.

[HueyLD]

Well, the worst I could do is still have my initial investment, less the taxes I would have paid annually. I don't know what to do, frankly. A 5-year jumbo CD is paying 1.85% ANY mix of stocks and bonds is too risky at this point, especially for my eldest child, who's only 4 years away from entering college. The youngest is 10 years away, so theres a little wiggle room there. Not much, but with the youngest there's at least SOME time to recover from a bad year or two. For the oldest... not so much.

I would take the sure thing of 1.85% over the so-called market-linked CDs. Here are warnings from the FDIC itself ( http://www.fdic.gov/consumers/consumer/ ... edcds.html ):

While most traditional CDs allow for early withdrawal after paying a penalty, most market-linked accounts do not.
....

With market-linked CDs, the formula for calculating the return may be extremely complex. Some banks will offer a return solely based on the performance of the market-linked index while others may also offer an additional minimal guaranteed return.

Start by looking at the disclosures for the CD. You should understand how a particular increase in the value of the underlying index during the full term of the CD, minus any fees (such as sales charges by a deposit broker), would translate into your actual return.

And look carefully at the terms for the CD. “You may find that your share of any uptick in an index will be limited to a certain percentage and subject to a maximum cap,” said Meron Wondwosen, an FDIC Consumer Affairs Specialist. “For example, it’s possible for the market index to increase by 25 percent but your actual return on the CD may be only 10 percent.”
....................


Some market-linked and other long-term, high-yield CDs have “call” features in their contract giving the bank — not the depositor — the right to close the account early without paying a penalty. The bank is most likely to exercise this option when interest rates fall, which means a callable CD would limit your ability to lock in an attractive interest rate for a long time.

For example, a bank might decide to call for the early redemption of a 10-year CD after only a year or two if market rates on new CDs have dropped significantly. “You’d get back your money plus accrued interest, but your earnings will likely be less than if the CD had been held to maturity,” Wondwosen said. “Of course, you could turn around and purchase another CD, but most likely it will have a lower interest rate.”

Don't invest in something that you don't understand. Please proceed with caution.

[RenoJay]

I would take your wife's suggestion. Just be sure the amount you're putting into the CD is within FDIC coverage range. Also, if interest is not covered by FDIC, then have the bank automatically deposit your interest in a different FDIC account elsewhere. (I have a couple CD's that are at the FDIC coverage limits with Ally and DiscoverBank and the interest automatically shows up in my checking account at BofA every month. Therefore, all I would need back if Ally or DiscoverBank failed was my principle.)

Also, some of us DO believe in a bond bubble. Just because prices are transparent does not mean they're rational given the risk. Prices were relatively transparent for stocks in 2000 and houses in 2005, but those turned out to be bubbles. Of course we'll never know til later, but to me, current bond yields don't justify the potential loss of principle if rates suddenly increase and you're stuck in a longer term bond.

[tfb]

Back in April 2010, I looked at one market linked CD with these terms:

5-year CD
100% linked to Rogers International Commodity Index total return minus 3-month T-Bills
point to point, no interim caps or averaging
maximum 60% cumulative return for the 5 years
minimum 0% return (return of principal)

The best 5-year CD was paying 3.5% at that time.

Now it's a little over 2-1/2 years. The index is up about 14%. The 3.5% CD would be credited about 9%. It's not obvious at the end of 5 years, the market linked CD will be worth less than the regular CD. That was against a 3.5% CD. The bar is lower today with the best 5-year CD paying about 2%.

[RandyAdams1978]

You guys are great. I just wanted to say that first. Thank you for all the thoughtful replies.

Wife still has MAJOR objections to 529 plans, including, but not limited to, loss of principal (value could go down) and loss of control (good for qualified expenses only, paperwork hassles, etc.). And, in a way, I can't really blame her. I need to come up with some balanced approach. Diversify, right? Maybe I put 100K in the jumbo CD (that's the minimum needed for jumbo status, but you guys knew that, right?), then put .... maybe 25K ... into each kids' 529 account???????

On top of that, I could try to find a market-linked CD that I understand ( I've read and re-read the FDIC warnings, HueyLD. I've even gone over some Term Sheets I found laying around the web. Some make my head swim more than others). I could put ... thinking out loud here .... 50K into one of those. Truth be told, though ... paying taxes on phantom income is more than a little disconcerting. I would need to REALLY understand that part of the MLCD prior to signing on the dotted line.

100K Jumbo CD
75K 529 plans
50K MLCD
50K left over to invest in ... ??? ... tax managed/tax exempt VG funds?????

Sometimes I think... "Man, if I lived under a bridge, I wouldn't have these problems."

livesoft: You're right, of course, on the not needing it all in 4 years. I was even tinkering with the idea of putting the eldest son's 529 in "safe" stuff, then getting much more aggressive with the youngest's portion. If needed, I can switch beneficiaries to maximize results. My wife might call that gambling, though.

tfb: on a 3.5% CD, you're right... if the index stays at 14%, the MLCD loses. The best jumbo out there now pays 1.85%. The MLCD you mentioned is beating that. For now.

[RandyAdams1978]

Upon further investigation, it looks like MLCDs are off the table. Too many google search results started with "(Insert Issuer name here) Under Investigation For (insert structured product name here)".

And I did find some more term sheets here:
http://www.structuredinvestments.com/Offerings/Broker_Dealer_Offerings.aspx

First of all, they're callable. Secondly, the duration is too long. And thirdly, the "terms" are not understandable. Not by me anyway.

*sigh*... Next!

[LadyGeek]

...Next! Read the wiki: 529 Plans

Are any of your wife's concerns addressed?

[Ozonewanderer]

My personal guideline is that any money I need within the next seven years should not be in the stock market. My second guideline is that any money invested in the stock market should have a time horizon of at least 15 years.

I would not put any college funds into the stock market if yo need the money within the next few years.