12/16/08

Index Linked CDs, Are They Worth It?

In this new era of extremely low interest rates, is it possible to get a decent return without taking on too much risk?

One way to limit your losses and stay in the stock market to participate in any upward gains is to take a loss upfront by buying puts on your stock positions. But how would you like to participate in the stock market's returns with no risk to your principal? Index linked certificates of deposit, or ICDs, promise to let you do just that, and are starting to be recommended by some financial advisors. Although they have been around for years, ICDs are relatively obscure and not widely available.

ICDs are similar to regular CDs, in that they are FDIC insured and sold by banks. As long as you stay within FDIC limits, you cannot lose your principal (unless the FDIC goes bust).

ICDs differ from regular CDs in how your returns are determined. These certificates of deposit are linked to stock market indexes, most commonly the S&P 500 or the DJIA but also the Nasdaq and even currency and commodity indexes, and their rates depend on how the index does. ICD maturities usually range from one to five years, and any interest due is usually determined at maturity.

ICDs differ from bank to bank. Some typical offerings provide from 85% to 100% participation in the index's gains. So, if the market goes up 10% from when you buy the ICD to when it matures, you could potentially get from an 8.5% to a 10% return. If the market goes down between the time you buy the ICD and when it matures, you get your principal back. Some banks have in the past offered a minimum return no matter what the market does. In such a case, you would get a gain even if the market goes down.

The only risks appear to be losing to inflation and giving up sure gains in equally safe investments like regular CDs or Treasuries. But there are a few things to note.

One thing to look out for is how the bank measures an index's return. Say the S&P 500 is at 1,000 when you buy your ICD and is at 1,200 when the ICD matures. Had you bought the individual stocks or the ETF (SPY), you would have a 20% gain plus dividends (which should be around 2 to 3% per year). Would you receive a 20% return on the ICD? Probably not.

For example, the bank may measure the index's return by averaging the index's closing prices for a certain period (maybe every trading day, or a set of specific "pricing" days, etc). Using the above example, the S&P 500 may be all over the place between the 1,000 when you buy the ICD and the 1,200 when the ICD matures. It may be around 800 for a while, who knows. It can turn out that the average closing price during your holding period is well below 1,200. Let's say it's 1090. Your return on the ICD would thus be 9%, even though it's "100% linked" to the S&P 500.

There are other considerations. For example, holding SPY for over a year and selling it for a 20% gain should give you a smaller tax bill (capital gain) than a 20% gain on an ICD (ordinary income). With the ICD you also miss out on the dividends you would have received if you owned the stock index. If the market is higher when the ICD matures than it was when you bought the ICD, the ICD will most likely underperform. If the market stays flat, you will probably get little to no return with the ICD, which may be smaller than the dividends you would have received with the stock index. That's better than losing money in stocks, but a regular CD might outperform an ICD in every case.

The fine print may have other qualifications. For example, there may be a cap on gains or the bank may be able to call the ICD when a certain event occurs. The market can go up 100%, but if the cap is at 11%, that's the most you can make.

Liquidity is something else to think about. If you own the ETF and suddenly need the money, you can sell it as soon as the market opens or in extra hours trading. Whether you lose any money on the sale depends on the ETF's market price. With the ETF, you have the option of selling a portion of your stake. If you own the ICD and need the money, you are likely to incur a withdrawal penalty and possibly face a delay before you get your money back. If you would like to redeem a portion of your ICD rather than the entire investment, that may be difficult or impossible. If the bank goes out of business, it may also take a while to get your money.

Related to liquidity, since the interest you earn with most ICDs is paid at maturity, you will not get current income from most ICDs.

The question then arises, given all these uncertainties (except for the fact that you won't lose your principal), why would anyone want to buy these products? The only answer I can think of is to try to beat inflation. Pinning returns to stocks while giving up some of the upside potential in exchange for no downside risk (in terms of principal, not purchasing power) can be a way to do that. I Savings Bonds ($5,000 a year limit) and inflation protected bonds seem a better way to go, however.

Unless you find an ICD with a guaranteed minimum return you'd be happy with, it's probably not worth the trouble.

If you are interested, below are a few banks that offer ICDs. These are not recommendations. They are posted for your convenience. Please read the fine print carefully, do your own research, and consult your financial or tax advisor to see if it is the right thing for you.

Everbank

Harris Bank

Stanford International Bank (Not clear if FDIC insured)

Washington Mutual (Chase)

Wells Fargo

Weymouth Bank

This is obviously not a complete list. Small local banks are probably the largest sellers of ICDs, so if you are interested, see the banks in your community.

Disclosure: At the time of writing, I own puts on SPY. I also own Wells Fargo stock, on which I wrote calls.


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