I was speaking to a representative at Wells Fargo today when she pushed their Market Linked Certificate of Deposit (MLCD). To be honest, I knew nothing about it so I did a little research.
How It Works
Basically, Market Linked CDs are like traditional CDs but instead of a fixed interest rate, the CD’s returns can be tied to a major index like the Dow Jones Industrial Average of the S&P 500. The return can also be linked to commodity prices, currencies, and even benchmarks like the Consumer Price Index (CPI) so this allows retail investors to invest in areas that are otherwise too complicated to get into.
The interesting thing to note is that these CDs are backed by the FDIC so they are insured. On top of that, it is set up so if the benchmark (or index) falls by the maturity date, you still get your principal back!
Advantages of Market Linked CDs
These MLCDs seem to be a marriage between the stock market with the traditional CDs that we are familiar with. The advantages are as follows:
- FDIC Insurance – Yup the principal is insured to a maximum of $250,000 this year and up to $100,000 thereafter, just like any other savings accounts or CDs.
- Unlike the stock market, you are guaranteed to get your principal back as long as you don’t withdraw before the maturity date
- Keeps you from buying and selling since a CD gives you the “locked-up” effect that traditional CDs provide (lack of liquidity can sometimes be a good thing)
Possible Gotchas
MLCDs sound almost too good to be true since it’s got all the upside rewards but none of the downside risks! Of course, once you look into it further, it’s not perfect.
- Early Withdrawal Penalties - Even though the principal is guaranteed if you hold it to maturity, this is not the case for early withdrawals. Therefore, it might be possible to have a huge withdrawal penalty if you need the money before maturity.
- Bad Tax Rates – Your returns are considered interests so even though it might be from the performance of a stock market, it doesn’t qualify for the long term tax rate of 15%.
- Ugly Tax Treatment – Furthermore, there’s a quirky rule that says you have to report returns as income every year you own this CD (if held in a taxable account). So while you might not even receive anything until maturity, you have to pay taxes on some return (the return is based on a traditional CD that the bank deems comparable).
- Possible Upper Limit – Some MLCDs have a cap on the high end that limits the returns, so the comparable index returning 100% doesn’t mean you will get a 100% return in your MLCD investment.
- Dividend Reinvestment – A big chunk of market returns are actually provided by the dividends that the company pays. Investing in MLCDs that track the index will not benefit from this.
What I Think of MLCDs
The tax implications really turns me off so this option for taxable accounts are automatically out of the question. It’s not just the higher tax rate, but needing to pay taxes on money that I don’t even have yet really turns me off.
As for IRAs, the guarantee of no lost of principal is really great but as I have a very long time horizon, strictly investing in index funds is a much simpler strategy than investing in MLCDs due to the fact that I can’t imagine the S&P 500 being much lower than it is now in something like 35 years in the future (Remember that even if the index is lower, I would’ve reaped the benefits of reinvesting the dividends).
Who could really benefit from something like this are people who will retire in the next 10 years. These people might not have the time horizon to wait for the stock market to come back, so giving up the dividends might be worth it to lower the risk of possibly another market crash before retirement.
Have you thought about this type of investments and do you own any? Will you consider it? What do you think?
Update: My dad sent me an email with a good way to take advantage of this. If the MLCDs have short terms (like 3 to 6 months), then it’s a great way to make money since you can take advantage of the volatility and only pocket the interests when the benchmark goes up!! This is almost like free money but then I checked a bunch of offerings and they all have 3 year terms at a minimum. No free lunch this time!
- E*Trade IRA - Official Site
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{ 21 comments… read them below or add one }
We have one setup 2 years ago and boy am I glad I did this. While everyone is getting upset about the market, all I really lost was the 5% or so a year if I chose the traditional CD option.
I know it was plain dumb luck that I invested in this rather than an index fund or something but it worked out for me! It also helped that it’s offered by my bank (who I trust).
Never heard of it either. The tax things is a negative, may scare people off. What would be the most efficient way to go about it? Would you recommend for short or long term with one of these?
Sandy: Good to hear that luck is sometimes on our side!
When that CD matures and if you decide to take advantage of another similar MLCD, just make sure that it doesn’t have a cap so you can take advantage of the run up when the market comes back!
Craig: It really depends what you mean by “long term” (ie how far out is your horizon when you say long term). If it’s 5, 10 or more, I’d say just stay away from these and buy a low cost index fund. if it’s short, then perhaps these market linked cds provide a good medium between safe and aggressive.
I wonder why my banker never talked to me about this. I will ask him about it and see what he says. I suspect that he didn’t want clients like me complaining to him come tax time. I totally agree, that tax thing is really “quirky” (as you put it).
Thanks for the explanation though. I’m off to calling him now!
I think the question potential market-linked CD investors need to ask themselves is “Do I understand and feel comfortable investing in stock options?”, because that’s what you’re essentially doing. MLCDs are a retail version of Principal Protected Notes, a range of products offered to fixed income investors to boost their returns during bull markets. Like other financial innovations of late, this product is right for a small niche of investors. As for me and my portfolio, my liquid funds are in CDs and my investments are in index ETFs and never the twain shall meet (at least for now!)
Ross: Let us know what he says! I’d love to hear his reasons!
Anthony: But isn’t MLCD a much safer way than investing in options? Normally if someone is buying options, it’s all or nothing. At least with MLCDs, the principal seem to be protected (that’s of course assuming the FDIC is safe).
MoneyNing: A MLCD is no riskier than opening a CD and purchasing call options on SPY (for example) separately. To reconstruct a MLCD myself, say I place $100,000 in a 9-month ING CD @ 2.25%. This amounts to about $250 per month of interest. Then I buy 10 nearest at-the-money call option contracts for SPY (09 Sep 89.00 for $10.40 apiece, $104.00 total). Now I have $146 leftover and I’ll receive any upside of the S&P 500. In the absences of arbitrage, a retail MLCD and my DIY approach should have the same yield.
Note: Because of the limited upside mentioned above, I suspect that a bull call spread is used rather than just simple call options. But that’s a whole other ball of wax!
Anthony: Thanks for the example! I can appreciate having the math be the same, but I’m sure you agree that this is obviously much more complicated for the average person right? Most people don’t even own a brokerage account, let alone having one where you can trade options.
This is interesting though, and one where I will definitely investigate more! Thanks again for the lesson
MoneyNing: You’re absolutely right – nothing is a simple as I’ve made it sound. I’ve made a lot of assumptions, but the idea was to give you an intuition of the mechanics as you research MLCDs further. I’m glad my example helped!
I should clarify why MLCDs are not of interest to me, the retail investor. These products are targeted towards investors of a certain asset size (probably large) and a certain time horizon (probably short to medium). I’m out on both of those criteria. But, more importantly, I’m young enough and my portfolio is diversified enough that I don’t want to be limited on my upside and I don’t care if another October 2008 hits again. To someone closer to retirement and of grander means, this might be a good product.
Anthony: MLCD is a tough sell with all those quirks and not much benefit. It would seem that people who want the extra risk (no interests and inflexibility) would rather buy stocks outright.
I’m sure some of the younger folks are “almost happy” with this crash since it gives them a much better entry point going forward as they continue to pour money in. The same event wasn’t so great for people who are older though!
I just looked into this for my daughter’ education fund. My daughters don’t make enough a year to have a tax burden, so my understanding is the tax on the yields will be irrelevant.
Here is why I think this makes sense for me right now. If you read Barrons this weekend, then you might be a depressed as me! The panel of experts was very gloomy on the near term potential of stocks and the indexs — they seemed to agree that there would be short (and possibly substantial) rallies, but that the fundamentals pointed to a very tough, and low market over the next 1-5 years.
So I want to protect against the downside of the S&P settling below its current level for several years (not likely, but a real possibility). At the same time, I don’t want to miss a real rally from this point — approx 900 — to a possible 1200.
The way it was explained to me, the way this investment works is that the bank leverages your MLCD by using it as collateral to place long and short options on the index. They bracket the performance of these options so that if the market ever exceeds the performance of their option positions, those positions are immediately liquidated and profits captured — this could happen well before your maturity date, and locks the returns on your CD. This is partly the reason your returns are capped, because they intend to liquidate the option positions once those returns (plus some for the bank) are achieved. They are playing volatility in the market.
So essentially, you are play the volatility of the market for its potential upside with FDIC insured principal protection – and a guaranteed 5% gross return (on their S&P index) — 2 yr equals about 2.5% per year. The max potential gain on this MLCD is 23% gross return. And you make this play without the headache making option trades yourself.
The only downside is that if the market has gone up MORE than your max gain, when the MLCD expires, you will have to buy into the market at that price, that is if you want to be in the S&P then.
This would be perfect on a 1 year horizon, but it is only offered on a 2 year horizon. But I can live with that. Afterall, its not out of the question that the economic situation may look worse in 2 years than today. But I would bet that there will be enough volatility between now and that the might hit its max return.
Let me know if you find serious flaws in my understanding or logic!!
Thanks.
Jeff Shaffer: You’ve done your research and have a good understanding of an MLCDs’ under-the-hood mechanics. Allow me a few comments:
- The CD portion of the MLCD is not used as collateral by the bank – the FDIC would have a problem with that. Instead, it is the investment spinning off interest used to purchase the options on whatever the “market” is defined as (e.g. the S&P 500).
- Be wary of any claims of “guaranteed” returns (e.g. Madoff, anyone?). All you are guaranteed to receive in the end is your principal back and whatever interest the bank agrees to pay if the market tanks for the entire duration of the CD.
- It is a pain to post margin and trade options. Just don’t confuse convenience with risk-free. All other things being equal, an investor would find a MLCD to be just as risky or risk-free as opening a CD at their bank and using the interest earned to purchase options at various strike prices and at various expiration dates.
I hope my comments are helpful. And good luck on investing your daughter’s eduction fund. Hopefully, the market will be on your side.
Anthony and Jeff,
As someone who almost marketed some of these, there are some that do guarantee a return, but the few that did were quite low. I think some of these were becoming “hot” in 2007, and even then the highest guaranteed was 3%.
Jeff, read carefully. I would be leary of someone promising a return that seems to good to be true in the current market. Most CDs are paying in the 2.50% to 3.50% range. A 5% guarantee seems too high in this market.
Dear CD Rates,
One small clarification on your comment on my post that the MLCD earned 5% — my post noted it is a 5% GROSS return on a 2 year hold — that works about to just under a 2.5% annual interest rate — which is about market today.
Thank you for the correction. I did miss that.
cd :O)
I deposited a couple of checks at Wells Fargo today and they noticed that my account balanced jumped $160,000 from the previous month. The reason for this was I had sold my deceased brother’s condo that I inherited and had the proceeds wired into my account. The teller explained that my simple checking account was too basic for that high of a balance. She asked if I wanted to discuss other account possibilities (that would give me a return) with a banker. I agreed and explained that I wanted to protect the principal, keep the funds liquid and get a small return in a savings type account. The investment banking specialists thought that their current 3.5 Year Wells Fargo S&P 500 Certificates of Deposit Barrier Return with Contingent Rebate was a great choice to invest the $100,000 in and then suggested I leave the other $60,000 in an interest bearing savings account. They stated I could very well earn 35-52% of my money if the S&P rebounds and their would be no risk due to the principal being FDIC insured. But then at home I found the catch. The key is the last five words of the name of the product “Barrier Return with Contingent Rebate”. The information sheet states that this means that “Investors receive the point to point appreciation of the SPX as long as the closing level on any day during the term does not exceed a barrier of [48% to 52%] above the initial level…If the index closes beyond the barrier on any day, the depositor will receive their principal plus a 10% rebate (2.75% APY) at maturity. So basically, if I get in with 100K and the S&P is at 800 and then it jumps to 1400 in the middle of the second year, I will receive only $10,000 or (2.75% APY). What a deal for the bankers to finance their Las Vegas junkets to the Encore resort in Las Vegas! The additional tax headaches of having to pay taxes on appreciations you haven’t received yet are a turnoff as well. I also wouldn’t want to wait the whole 3.5 years to get my 2.75% if the market were to exceed the 52% during the term. Compounding interest in the Etrade and HSBC online savings accounts that currently provide a 3.01% and 2.60% APY are the way I am going to go.
Greg: That is very interesting. Thanks for bringing a specific MLCD example to the discussion. Since this post early last month, I’ve been wondering about the specific parameters of a MLCD. Now we know.
The barrier return option makes a lot of sense for the bank. They don’t want to lose their shirts should the market (e.g. SPX) rally. Of course, what is likely to help the bank isn’t likely to help you. This illustrates another reason why I’m not too keen on MLCD products. Personally, I think your savings should be in savings and your investing should be in investments.
I just wanted to interject before any readers get the wrong idea. Not ALL MLCDs have a Barrier with Contingent Rebate feature, this is just one specific example of the way that a Market Linked CD might be structured in order to give the investor exposure to equity market upside while still in a fully principal protected form. These structures can also be leveraged (such as providing the investor with 114-125% of the return of the underlying market) and can be a great way for investors to gain access to markets that are not always easily gained from an individual’s standpoint (such as some algorithmic indices, currencies, commodities).
You cant get something for nothing, we all know this, so when you are investing in a product that guarantees your return of principal at maturity (NO downside risk), you may have to give up something comparable on the upside in return for that feature (risk/return tradeoff) –> this is where the barrier feature comes in. It is NOT because the bank doesnt “want to lose their shirts should the market rally” Anthony. The banks who sell these MLCDs are actually not on the other side of the trade (i.e. they do not make money when you lose money), they use the interest from the investment in the CD to buy options that in turn give you the payout of the underlying index, and therefore it is not a you win i lose type of situation.
Thanks folks. Today we went through this routine with the banker and because of your varied comments, we’ve decided to pass on this. Really appreciate your perspectives and opinions.
After reading this blog I felt that I should share my decision-making process when I decided to invest on a MLCD in January. The 3.5-year MLCD that I purchased with Wells Fargo gurantees at least 9% return until it matures as long as the S&P 500 index after 3.5 years is higher than the initial value (approximately 800 pts in 1/31/09). If the S&P 500 index is below 800 after 3.5 years I only get my principal back (it is FDIC insured). This is a 2.5% yearly return which is about the same return anyone could get with a regular CD that matures in 3.5 years (1 year in the low 2% and 5 years in the high 2%). Given the fact that I don’t have the nerves to watch my short/medium term investments go up and down in the stock market but I also don’t like the idea of leaving money on the table, this instrument seems to provide a unique alternative to get some upside (yes, cap between 50% and 60% from the initial S&P 500 800 mark – I can’t remember the exact number from the top of my head). Yes, the tax and dividend issues brought up aren’t attractive but the alternative would be to invest in a regular CD with very similar return (~2.5%), tax (the difference is having the interest available to pay tax but the amount is not outrageous anyway), and dividend (there is no dividend in regular CDs) implications. Thus, if one can see this as an opportunity to gain up to 50%-60% in 3.5 years (12.3%-14.4% per year – all before taxes) without taking any risk of losing the principal and without doing any extra homework to buy stock options, I believe it is a good instrument. I have never been a fan of investing in stocks for short/medium term savings. If you want to invest in equities and you don’t have the time, nerves, or expertise to take action on a daily basis, I think the best option is mutual funds with low admin costs targeting long term goals. That’s at least what I do by having mutual funds with long term target goals. Finally, I think the market today is such that even if it goes much lower it will probably recover in 3.5 years. However, if you are concerned about losing your principal but still want to benefit if things get better very quickly, why not purchase some MLCDs? The way I see if the market gains more than 60% in 3.5 years: I will still be happy since my retirement account would have recovered a good portion of its current loss (no cap on it) and the economy will be getting better. If the market goes even lower, well, I can at least get my principal back and not regret putting more money in stocks. And yes, I will be very sad when I see my retirement account’s balance. Have I convinced anyone that MLCDs can be a good investment?
It really comes down to the amount your investing (compared to you total assets)and your liquidity needs. From what you have described, the Wells Fargo MLCD product you invested in has no Barrier Return with Contingent Rebate which is a positive. Having no risk on the principal is also good, but I wonder how much of a bureaucratic hassle it would be to work with the FDIC to put in your claim if the S&P were below that 800 upon maturity.