Market-linked CD

A market-linked CD (MLCD), also referred to as an equity-linked CD, market-indexed CD or index CD, is a certificate of deposit that is linked to the performance of of a securities or market index. There are market-linked CDs linked to stocks, commodities, currencies, as well as inflation. Chase Manhattan Bank of New York was the first to offer an equity-linked CD in March 1987, and at least nine other large banks subsequently offered these instruments during the year.

How a market-linked CD works
Participation rates, interest rate caps, and the presence or absence of a call provision are key elements in determining how much interest a market-linked CD will provide.


 * Participation rate. The participation rate is the percentage at which a market-linked CD’s annual return will correspond to the performance of its target index. For example, if an index sees a 12 percent gain, and the CD linked to it has a participation rate of 75%, the CD will produce a return of (12 x 75%), 9.0 percent.
 * Interest cap. The CD may also contain a cap on the amount of interest an investor can earn. Example: If the CD in the prior example (12 percent index return) had an 8 percent cap, this is what the investor would earn.
 * Call provisions. Some market-linked CDs have a call feature which allows the issuing institution to redeem the CD before it matures. The call price determines the investor's interest earnings. This can be lower than would be the case if the CD were held until maturity.

Calculation of return
The most common methods used for calculating market-linked CD interest are a point to point method and an averaging method.
 * Point to point. This computation uses the starting point value of the index when the CD is issued and the ending point value of that same index just before maturity as the reference points for interest return. The CD return is the difference, or, depending on the participation rate, a percentage, of the difference of this return.
 * Averaging.Rather than calculating the return based on a starting and ending point, the values of the index along several “observation points,” or dates, are averaged. With averaging, the interest rates can be capped; there is no cap for negative returns, and the sequence of returns can have large effects on the final return.

Taxation
If held in a taxable account, the interest earned on a market-linked CD is taxed at marginal tax rates. Furthermore, over the term of the CD, an investor is required to report an annual "imputed" income from the CD to the IRS and pay tax on this "income" even though the actual earned interest will not be determined until maturity of the CD. Thus, if the final interest from the CD is 0 dollars, an investor will have prepaid tax on non-earned income.

FDIC coverage
The FDIC deposit insurance will cover the principal of the market-linked CD but does not cover the interest until it is paid out at the CD's maturity.

Forum discussions

 * Structured CD's From Goldman Sacks, by Larry Swedroe
 * Bogleheads • View topic - Structured CD's From Goldman Sacks