Before choosing what kind of CD to invest in, it’s important to understand how market-linked CDs differ from traditional CDs, which provide a fixed rate of return. Understanding how market-linked CDs work can help you make more informed investment decisions.
Definition and Examples of a Market-Linked CD
A market-linked CD is a certificate of deposit that contains a fixed sum of money and is held for a set amount of time, also known as a term, which ends on a maturity date. Unlike other types of CDs, a market-linked CD is tied to underlying market returns instead of fixed interest rates.
Alternate names: Variable-rate CD, equity-linked CD
For example, a market-linked CD might be based on the S&P 500 index. If the index goes up during the CD’s term, you might participate in some of that upside and perhaps earn more than you could with fixed-rate CDs. However, there’s no guarantee that the market will outperform the interest rates provided by traditional CDs.
How a Market-Linked CD Works
Market-linked CDs hold a fixed sum until an agreed-upon maturity date, and their returns are tied to an underlying market such as a stock index. However, financial institutions may provide very different terms regarding market-linked CD returns, so it’s important to read the fine print. For example, market-linked CDs can have varying participation rates, which determine the percentage of a return your CD can capture. If a market-linked CD offers a 100% participation rate, you could capture the full return of the underlying market. But a 90% participation rate would mean you only get 90% of the return. That means a 10% stock market gain might only yield a 9% return on your market-linked CD. On the flip side, market-linked CDs also protect your principal investment. As long as you hold the CD until the maturity date, your principal is guaranteed—even if the market takes a downturn. For example, if you put $10,000 into an index fund that tracks the S&P 500 and the index falls by 10%, you might be left with $9,000. But if you had put the same $10,000 into a market-linked CD and held it to maturity, you’d get back the full $10,000, even though the market declined.
Market-Linked CDs vs. Traditional CDs
Also keep in mind that market-linked CDs can have some unique and complex tax characteristics, such as triggering taxes on annual yield even prior to the CD’s maturity date, when the investor has not yet received that money. If you’re thinking about investing in a market-linked CD, consider speaking with a relevant professional to determine the best way to manage these investments.
