A market-linked CD is a certificate of deposit with a return based on variable underlying market measures, such as indexes, commodities, or currencies.
Before choosing what kind of CDs 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.
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Market-linked CD terms may also cap the total return. For example, a 20% cap could mean that even if the participation rate is 100%, a 25% stock market gain could still only mean a 20% gain for your investment.
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.
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If you want to take your money out of a market-linked CD before the maturity date, you might be able to sell it (although there’s no guarantee), but you might lose some of your principal.
Market-Linked CDs vs. Traditional CDs
| Market-Linked CDs | Traditional CDs |
|---|---|
| Returns are unknown until the maturity date | Returns are fixed and you can generally calculate them from the start |
| Can be based on many different market measures, such as the performance of certain stock indexes | Based on interest rates at the time you open the CD |
| Typically involve fees | Typically do not involve fees besides potential early withdrawal penalties |
| Often have multi-year terms | Terms can range from short to long (eg, six months to six years, among many other options) |
| Minimum opening deposits required, such as $1,000 or more | May have no minimum opening deposit or a low minimum (eg, $500) |
What a Market-Linked CD Means for Individuals
Understanding market-linked CDs can help individuals make better investment decisions. For some individuals, market-linked CDs might be an attractive option to get exposure to different markets. Others might prefer to invest directly in those markets. Some investors might prefer the fixed rate of return from a traditional CD.
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.
Key Takeaways
- Market-linked CDs base returns on underlying markets, such as those for stocks, indexes, commodities, or currencies.
- Market-linked CDs can protect your principal if held to maturity, but you must weigh that protection against the liquidity risk.
- Financial institutions can differ widely regarding the types and terms of the market-linked CDs they offer.
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