What is a market-linked CD? A market-linked CD is a certificate of deposit whose return is linked to the stock market or a similar type of investment. Basically, the CD is FDIC insured protecting your principal while the CD's funds are invested in a more aggressive investment.
How does this work? Market-linked CDs come in a variety of options. The most important part of any market-linked CD is for it to be FDIC insured. Some have been offered without this protection, but the idea behind this investment is to have it protected from downside risk, i.e. a market drop, while still participating in the stock market. The CD is placed in an account with a bank or brokerage which then takes the principal and invests it in a riskier agreed upon investment. These investments can vary from five stocks to an index such as the S&P 500 to even commodities.
So what's the catch? The investors upside potential return of the investment is capped. Just as the downside risk is mitigated with the FDIC insurance, the upside return is capped so the bank or brokerage receives a portion of the gain. Here's an example: $10,000 is invested in the CD with FDIC protection and the bank then invests that $10,000 into the 5 stocks that have been offered with that CD. The first year the stocks lose 30% of their value but the principal is safe remaining at $10,000. The second year the stocks are up 30% but the bank caps the investor's gain at 10% keeping the remaining 20% for the bank. The CD would then be worth $11,000.
Some CDs come with a minimum guaranteed interest rate. In the above example, if the minimum guarantee was 1% then even if the stocks did lose value the CD would have return the 1%. The $10,000 would have been worth $10,100. However, most market-linked CDs are not that generous. There will be a minimum guarantee but a much lower cap on the stock market return to the investor. If the payout were 10% then most likely no minimum guarantee would be offered.
Another possible downside is that many CDs require the underlying stocks to all perform well. If the CD invests in 5 stocks, then all 5 have to do well and post positive gains or beat a set target that the market-linked CD agreement states. If even one stock did not perform to the set standards then the investor would only get the minimum guaranteed interest rate on the CD.
Most CDs require a fixed holding period as long as 5-10 years or longer. The CD's principal is safe if the investor stays invested through the entire holding period. If the investor wishes to withdraw money prior to the end of the holding period then the principal is not insured and the investor will receive only the current value of the stock investment minus a penalty. That is why a market-linked CD should only be for money the investor can leave untouched for the holding period. Otherwise, investing in the stock market directly would be a better investment.
Also, check the agreement for fees. There should be no fees other than the penalty for early withdrawal. Fees would make this investment a poor choice since the upside return is capped. As for taxes, a market-linked CD will be taxed at the investor's ordinary income tax rate just like a regular CD. There is no special capital gains tax treatment for a market-linked CD. Plus, in many cases the interest is accrued and not paid out until the end of the CD term and yet taxes are due the year the interest is accrued.
Overall, a market-linked CD may be an okay investment if you are very risk averse. Plus, if the U.S. Federal Reserve keeps rates low for another 3-4 years a market-linked CD has the potential to return more interest than a regular CD. This is done without the possible loss of principal involved in investing directly in the stock market. To take advantage of a market-linked CD, it is best to choose one that offers a guaranteed minimum interest rate equal to what regular CDs are paying. Also, only invest money that won't be needed during the holding period.
May I recommend my ebook, Investing $10K in 2013