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 ties its rate of return  to the performance 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.

MLCDs were in especially high demand in 2011. Banks sold a record 1,271 of them during the year, totaling an estimated $25 billion dollars. For the most part, MLCD's are purchased through a broker or registered investment advisor.

How a market-linked CD works
A market-linked CD is an FDIC-insured certificate of deposit that ties the rate of return to the performance of a market index such as, for example, the S&P 500 Composite Stock Price Index. The terms of these CDs vary; typically the term is five years. The financial institution calculates your rate of return on the date that the CD matures based on the particular terms of the contract. Therefore, there is no guarantee that any payment in excess of the guaranteed payment will be paid.

Refer to Figure 1. The horizontal axis is the return of the market's index (annual), while the vertical axis is the market-linked CD's performance. During times of high market returns (right side of graph), the CD's return will track the corresponding index until it reaches its interest cap rate. Above that value, the underlying security will outpace the CD and represent lost income compared to the security, i.e. the market cap will limit the upside gains.

During times of poor market returns, the market-linked CD will limit losses by holding its principal value (left side of graph). As the underlying security's return continues to drop, the CD can go no lower than its principal value, and the investor is protected from losing the original investment. If the investment was instead with the underlying security, the original investment will not be recovered (loss of principal). In this sense, a market-linked CD provides downside protection.




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 * align="center"|Market-Linked CD Return versus Market Index (Used with permission)
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 * align="center"|Market-Linked CD Return versus Market Index (Used with permission)
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Indexing method
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, and the sequence of returns can have large effects on the final return. There is no general rule for negative returns, as one specific CD may not have a floor for negative returns, but another may very well have a floor at each observation point.

Additional methods used for calculating interest include:
 * Sum of periodic returns feature. This computation is typically based on the sum of the returns measured over several set dates (monthly, quarterly, annually). Each period returns are often subject to a cap and/or a floor, where the floor on the downside may be significantly lower than the cap on the upside or where there may be no floor on the downside. As a result, the sum of periodic returns feature generally provides less opportunity for appreciation than a point-to-point return calculation.
 * Contingent periodic interest feature. This computation pays periodic interest payments contingent on the performance of the components of a basket. The contingent periodic interest payments, if any, are based on the sum of the weighted component returns of each of the basket components. Typically, the basket components are equally weighted and there are limits to the positive and negative component returns for each applicable valuation period. In most cases, the limit for negative component returns is significantly lower than the limit for positive component returns. As a result, if the return of one or more of the basket components is negative during a valuation period, such negative component returns could offset entirely any positive component returns generated by the other basket components during the same period, and the periodic interest would be equal to zero.

The term of investment, participation rates, interest rate caps, the presence or absence of a call provision, and minimum interest amounts are key elements in determining how much interest a market-linked CD will provide.


 * Term. An MLCD is issued with a set maturity date. Early withdrawals can result in stiff penalties.
 * Participation rate. The participation rate is the percentage at which an MLCD’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 MLCDs 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.
 * Minimum Indexed Interest Amount. Some MLCDs will provide a minimum amount of interest. For example, the CD disclosure document may state that the CD will provide a minimum 2 per cent return over the term of the CD. This will provide a 0.5 per cent annual percentage yield (APY). At maturity, an investor will receive the greater of interest earned by the crediting method or the minimum indexed interest amount.

Illiquidity
Market-linked CDs are illiquid and are designed to be held to term. There is no secondary market for the CDs. Early redemption can mean an investor will not get back the original deposit amount. Some MLCD's will provide scheduled early redemption dates, but the redemption value may be less than the deposit amount. Some MLCD's provide a survivor's option. In this instance, the CD issuer, in the case of death or adjudicated incompetence prior to the end of the CD term, will return the full original deposit, but no earnings, to the estate of the CD owner.

Return scenarios
The following MLCD illustration of return scenarios, as put forth in a First Union Bank disclosure document (for an S&P 500 Market-Linked Certificates of Deposit, due March 30, 2016 (MLCD No. 198) will serve as a window on how the return method used by the bank affects the interest returned to the investor.

In this MLCD, the bank uses a quarterly capped sum of periodic interest computation for crediting interest. For simplicity, the illustration is based on a $1,000 initial deposit. Here are the details:


 * Quarterly percentage change: is the lesser of the final quarterly value minus the beginning quarterly value divided by the beginning quarterly value; or the 4.00% quarterly cap. (Note that negative returns are not capped)
 * Indexed Interest Amount: The sum of the 16 Quarterly Percentage Changes of the Investment Benchmark multiplied by the outstanding Deposit Amount on the Maturity Date.
 * Maximum Indexed Interest Amount: 64.00% multiplied by the outstanding Deposit Amount on the Maturity Date. This equates to a 13.16% APY.
 * Minimum Indexed Interest Amount: 2.00% multiplied by the outstanding Deposit Amount on the Maturity Date. This equates to a 0.50% APY.
 * Payment at Maturity: The Deposit Amount plus the greater of (i) the Indexed Interest Amount or (ii) the Minimum Indexed Interest Amount.

The table below provides two scenarios. Both sequences end with same market index value (a 30% increase in market value) but the return sequence is varied. In the first scenario we are presented with a lower volatility general market advance, with only two negative quarters, and with only two quarters providing returns that are capped. This scenario provides a return that exceeds the minimum interest guaranteed by the bank.

The second scenario, although it ends with same market value as the first scenario, is punctuated by a two year bear market decline, followed by a generally sustained market rally. The scenario contains ten negative quarters, and four quarters with capped returns. This scenario produces a negative summed interest calculation, thus giving the investor the minimum interest (0.50%) guaranteed by the bank.

In addition, even if the the return scenario provides a positive sum under the averaging calculation, the MLCD might still only provide the minimum guaranteed amount if the return sequence includes a large percentage of negative return quarters. The disclosure document states: "The likelihood that on the Maturity Date you will receive only the return of your Deposit Amount and the Minimum Indexed Interest Amount increases as the number of negative Quarterly Percentage Changes increases." In addition, the document states that any single quarterly index return that equals or exceeds -58.00% will result in a minimum guaranteed interest payment.

If the crediting method in these two scenarios employed a full participation, uncapped point to point crediting method, the investor would have received a 30 per cent indexed interest amount, resulting in a $1,300 payment at maturity.



(view Google Spreadsheet in browser or download as xls, ods, or pdf)
 * align="center"|Table 1. Interest Crediting Scenarios
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Taxation
From a tax perspective, MLCDs are treated differently than conventional CDs. They are subject to special rules which require inclusion of income based on a comparable yield and projected payment schedule, as well as a special rule which requires recognition of ordinary income on any gain realized on a sale or other disposition.

Holders of MLCDs are required to report to the IRS all payments of principal, any premium, and interest on the MLCDs, and the accrual of OID (Original Issue Discount). In addition, holders are generally required to report to the IRS any payment of proceeds of the sale of an MLCD before maturity.

If held in a taxable account, the interest earned on an MLCD is treated as ordinary income and taxed at the  marginal rate. Furthermore, over the term of the CD, an investor is required to report this interest to the IRS and pay tax on this interest, 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 (up to the per insititution insurance limit) but does not cover the interest until it is paid out at the CD's maturity.

Creating your own indexed CD
An institutional investor can mimic an indexed CD by buying a conventional fixed rate certificate of deposit or a zero coupon bond that will mature at the starting capital value. This assures the investor that, if the position is held to term, there will be no loss of the original investment. The remaining capital not invested in the fixed investments can then purchase options on the market index the investor seeks to track. These can be stock market, commodity market, or currency market options.

However, the options available to individual investors cannot match those available to institutional investors which makes mimicing an MLCD unrealistic. In general, there is no way for an individual investor to truly mimic an MLCD.

It is also possible to lose downside protection if the securities fail to perform as expected. See A Case Study on an Equity Linked CD for an illustrative example.

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 * Goldman Sachs wins my Dubious Distinction Award, by Larry Swedroe