Ask Stacy: Are Market-Linked CDs a Good Investment?

Ask Stacy: Are Market-Linked CDs a Good Investment?
Photo (cc) by Ed Bierman

With interest rates on savings earning practically nothing, it’s little wonder I often field questions like this one:

What do you suggest for people with a lot of cash which is now in a money market and not earning much of anything, but who want something completely SAFE with LOW risk but gets a better interest rate?
— Dixie

Or this one:

Is there anything I can put my money in that is very low risk but better than the nothing that I get now?
— Nancy

Dealing with an interest drought

Guaranteed savings accounts are going through one of the worst interest droughts in history. Like refugees from the Dust Bowl, savers no longer able to scratch enough interest from their parched savings are being forced to wander in search of decent returns.

We’ve recently offered some potential solutions, including collectibles, peer lending and dividend-paying stocks. But none are free from either risk or hassle.

What’s a saver to do? If you’re like Dixie and Nancy — unwilling to take risk — then your only option is to wait for higher rates, which may come sooner than you think. But what should you avoid while you wait?

Stupid investment tricks

David Letterman’s Stupid Pet Tricks was a funny franchise that ran for 30 years. Wall Street’s stupid investment tricks have been going on longer, and they aren’t funny at all.

Case in point? Equity or market-indexed CDs.

My father-in-law went to the bank the other day to roll over a five-year CD within his retirement account. When he understandably balked at the miniscule rate he was expected to accept, he was introduced to an in-house, commission-based financial adviser. The adviser suggested a no-lose proposition: an FDIC-insured CD that also offered the potential for extra interest, courtesy of the stock market.

He forwarded the info and asked me to look it over. My first impression: This investment is as silly as a dog that says “Obama” or one that can hold a glass and drink from it.

To understand why, take a look at some of the terms of this five-year CD:

  • Minimum Rate: 0.75 percent
  • Maximum Rate: 5 percent
  • Basket of stocks the returns are tied to: Apple, Coke, IBM, Merck and Verizon
  • How interest is determined: Every year on the anniversary date, if all five stocks are higher than they were on the inception date, you earn 5 percent. If even one is lower, however, you earn 0.75 percent.

These rates don’t compound. In other words, you earn interest only on your original investment. If you invest $1,000 and happen to earn 5 percent, or $50, after year one, your investment is worth $1,050. But if you earn 5 percent the next year, it’s only paid on the original $1,000, not $1,050.

In addition, while you can cash out a traditional CD early and typically be penalized only interest, cash this CD early and you can lose principal.

After looking it over, here’s the response I sent to my father-in-law:

In the very limited way you intend to use it, I guess it’s OK. But barely. Salient points:

  • Expect to earn 0.75 percent rather than 5 percent. That’s the most likely scenario, because all five stocks have to be up on the anniversary date to earn the higher rate. Those odds aren’t good, even in a bull market, and this one is getting long in the tooth.
  • You’re most likely going to have to hold it for the entire five-year term in order to get your principal. So be certain you’ll have the liquidity elsewhere in your IRA to meet any cash requirements, such as required minimum IRA distributions.

Since capital preservation is the primary goal and this product, if held to maturity, will at least accomplish that goal, I guess it’s OK. But if you’re dealing with a lot of money, I’d encourage you to consider other options.

For example, look at CD search engines, and you can find five-year CD rates around 2 percent. That’s a sure thing that at least offers limited liquidity. Better yet, bite the bullet, take out a shorter term CD and wait for rates to rise.

In my opinion, this investment, like many pushed by commissioned Wall-Streeters, is just one of many stupid investment tricks offering more sizzle than steak.

Why do they do this?

Visit the cleaning products aisle in your local supermarket, and you’ll find literally hundreds of boxes, bottles, pods, wipes and packages of what boils down to soap. The packaging screams things like “NEW!”, “IMPROVED!” and the ever popular “NEW AND IMPROVED!” But how many meaningful improvements can really be made to cleaning products?

Because they can’t materially alter their products, the easiest option to goose sales is to simply repackage what they already offer and call it new.

Wall Street’s no different. When it comes to investments, boil it down, and you can either be an owner (stocks) or a loaner (bonds, CDs, etc.). That’s about it. Since they can’t materially alter their products, the easiest option to goose sales is to simply repackage what they already offer and call it new.

This is how stupid investment tricks are born.

Other opinions on market-based CDs

From an FDIC-issued consumer alert of Market-Linked CDs:

While some of these market-linked products might be right for some consumers, there are definitely potential risks and other issues to consider before investing.

If you’re considering a market-based CD, check out this alert. It has nine questions to ask before investing.

From a Forbes article called Equity Linked CDs: More Garbage Wall Street Wants To Feed You:

Are equity linked CDs a good deal? Perhaps for some investors. But, reviewing this offering reminded me of those words of wisdom that my mother used to whisper as she bounced me on her knee: “Son, there ain’t no such thing as a free lunch.” So true, Mom!

Got a question you’d like answered?

You can ask a question simply by hitting “reply” to our email newsletter. If you’re not subscribed, fix that right now by clicking here.

The questions I’m likeliest to answer are those that will interest other readers. In other words, don’t ask for super-specific advice that applies only to you. And if I don’t get to your question, promise not to hate me. I do my best, but I get way more questions than I have time to answer.

About me

I founded Money Talks News in 1991. I’ve earned a CPA (currently inactive), and have also earned licenses in stocks, commodities, options principal, mutual funds, life insurance, securities supervisor and real estate. Got some time to kill? You can learn more about me here.

Got more money questions? Browse lots more Ask Stacy answers here.

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