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
Related Posts
- Online, Local or National: Which Bank is Right for You?
- No Envelopes at the ATM to Deposit My Check
- Does Always Thinking About Money Really Make Me Happy?
- Everbank Review w. 70+ User Opinions
- Anatomy of a Wire Transfer Secret Shopper Scam
{ 49 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.
In researching these index CD I have some additional questions and thoughts. Since these products possibly produce yearly phantom income is it not possible that upon maturity you could get no gains yet have paid taxes each year based on your tax bracket? If true you paid income taxes on money you never got. Next question, some of these have callable features so if the market does well and there is no cap would it not be in the institutions best interests to pay the call feature and keep the majority of the gains for themselves? The “opportuity losses” to the investor can be quite substantial. The complexity of these CD alternatives are amazing. As it stands right now I think the only area these would work efficiently is if we have a terrible market over the entire CD term (because you’d at least get your money back based on FDIC coverage paying ability). It’s here I would normal say “or,” but this part gets very complicated as cap rates, call features, and market performance all have varying and potentially substantial degrees of impact on actual performance. Since the bank is interested in making as much money on your money with them I could easily see the end returns even in the best market at only approximately equal to normal CDs. The bank will always scrape everything of solid profits for themselves. The investor will get the least that’s structured in the contract. As I think about this any callable feature would end up making the client pay proportionately higher taxes then his final return would dictate. Since all returns are treated as income the client may get a 1099 for all the gains in the maturity year in addition to the phantom gains durring the term. This would further reduce any actual return received. In the end the client could pay out more in taxes then he received in gains thereby giving him an unusable loss while the bank can state he got a good return over that time. I really need to see how the end is handled. I can see how these can potentially always give a loss to the investor and have the investor think he received a gain.
“As it stands right now I think the only area these would work efficiently is if we have a terrible market over the entire CD term (because you’d at least get your money back based on FDIC coverage paying ability).” Let me add “less any taxes you paid out over the term of the CD. This would net you a loss if all you got back was your principle in the end” To anyone I would say stay away from these for 8 years so a real history can develope. Then you can determine if they have a real benefit in practice.
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.
1 yr later and Wells Fargo is still offering this product and pushed it to me today…. I am struck between entering into a MLCD or just buying more standard CDs at some of the current higher yields for longer terms like 5yr or even 10yr at near 4%
I only need the money for graduate school which is about 10 yrs from now.
Any recommendations?
Normally, I would recommend a mix of stocks and bonds in a diversified portfolio since your time frame is 10 years out, but because you need the money for graduate school, which is very important to you, I would keep them in safer investments. In your case, a MLCD might not be a bad idea, assuming you don’t need the potential gains that the CD interest could give you. The MLCD doesn’t have the tax advantage of stocks and bonds, but CDs don’t either so that part of it is the same.
Maybe what you can do is figure out how much money you’ll be getting with a 10 year CD and then factor that into your calculation. Also, you might want to figure out whether you can earn money in this 10 year time frame. The reason why this is important is that your income can supplement the money you’ve already saved up for graduate school, so if stocks/bonds take a dive (say, 9 and a half years from now), you don’t need to sell them at the worst moment.
Thanks for the feedback. Well here is the kicker, currently I am in my undergraduate and don’t plan to go to graduate school until about 10 yrs from now (maybe a little less) AND I am a full time student at the moment with no traditional income means (ie. part time job or full time job). My only income source is my parents and/or my savings accounts including the CDs which just accumulate interest income.
And to top it off, I am paying out of my savings for my school tuition and related expenses. I was thinking of getting an IRA account and then depositing the interest income from the savings every year into the account and then later withdrawing it under the allowed condition that the funds are used for higher education expenses so that I get some added tax benefits.
I was hoping if that would work, that I can add the MLCDs under the IRA account with a years contribution at my tax bracket (near nothing due to this years really low interest levels on most savings accounts including CDs) which is $5,000 as the limit I believe for me tax/income status. And with the MLCDs under the IRA then maybe I can offset the taxes incurred there that would have been otherwise pretty high assuming the MLCDs perform well (which I think is what I think Mr. Jeff Shaffer was talking about earlier in this post)
Id love to hear your thoughts on this.
Note: I have not verified that an IRA will actually be within my reach right now as a full time unemployed student. I need to ask a tax expert about that.
Oh and the 10 yr CDs I have are currently yielding 3.63% Interest with 3.70% APY (Interest is compounded daily and credited monthly.)
@Joseph: Given your 10-year time horizon, holding something like a 30/70 equity/bond allocation might make sense, if you can stomach it. As I mentioned before, I don’t like paying for the privilege of mixing products if I can get the same result myself. I think a good bond index fund would be superior since your time horizon is long enough and because CD rates are in the toilet right now. However, as rates can only go up, I would stick to something with a shorter duration (a la Vanguard Short-Term Bond Index) and stay away from Intermediate and longer funds.
Given that your goals are educational, perhaps you could look into a 529 plan? No tax-deductibility on the way in like an IRA, but the earnings coming out would be. Don’t know about any income requirements, but at least you wouldn’t have to worry about meeting the IRA withdrawal limitations and tracking the associated documentation carefully to avoid penalties.
Good luck.
Using CD interest to fund IRAs and then withdrawing it may work out mathematically, but I always advocate simplicity because unlike professionals who are always looking at the numbers, we “humans” don’t and often screw things up. Unless we have some type of software that automatically calculates the precise moves needed on a daily basis according to interest rates, returns, tax rule changes etc, I don’t recommend trying to mingle with CDs, IRAs all together with money you need for non-retirement purposes.
To put it simply, I would worry about retirement with retirement funds, and other means with tuition. the 529 plans that Anthony brought up is a good alternative, and one you should consider because of its tax benefits. However, 529 plans are for tuition only, and as much as you believe you will go to graduate school, many people end up not going back, especially after they’ve gotten a taste of income from a job and the lifestyle that brings. (ie, some people find it hard to give up their income and eat ramens again after having the occasional Ruth Chris dinners), so 529 plans may or may not be worth it because the penalties of not going to graduate school would be big.
Speaking of bonds, due to the near certainly that rates are going to go up, I would buy bonds instead of bond funds. I know it requires much more research and maintenance, but bonds need to be held to maturity and therefore your principle are not susceptible to rate fluctuations. Bond funds on the other hand are destined to fall in prices in the coming years if rates rises. For the most part, the next 10 years for bond funds will most likely not be as good as the last 10 years, so tread lightly.
3.70% may not sound like a lot, but for the zero risk that you are assuming with this investment, the rate is actually awesome in my opinion.
Another gotcha. The index falls enough you get your principle back, but Wells Fargo still issues 1099-OIDs as if you were paid interest. They will not issue any corrected forms, so you pay tax on interest never received.
Hi,
Today we got some info on the HSBC equity backed CDs with 6 years …From reading the comments above, it looks like 6 years is not good ..also they have a cap of 7-10%.
Also, can someone clarify on the “will pay tax on something I have not received yet”….we are supposed to get the interest payout annually —so we have to pay tax at the income tax rate on this component or the statement is referring to something else.
Also, talking to bank official i got the following impression but i think there is a catch…
i put in 100k today
after a year my account could be valued at lets say 150k (not sure if this can ever happen), i can withdraw the amount less the penalty 3.5%.no other charges..would like to know what you guys think….
thanks
chitra
The actual product name that I was referring to is HSBC global industry titans series 7
chitra
Chitra: More details about HSBC CD issues can be found at http://www.us.hsbc.com/1/2/3/personal/other-services/structured-cd. On page 21 is a chart showing the interest HSBC “assumes” they will pay you for income tax purposes (assuming you are a US investor). For example, a down year could wipe out your coupon, but you will still pay taxes on the “projected” income.
With respect to early-redemption, the value of the CD is just as likely to go from $100K to $150K as it is to fall to $50K – you just happen to have a floor at $100K. So, the early redemption value would likely be $100K – $3.5K if the securities declined in value.
As great as a “geographically diverse basket of twelve publicly traded securities” sounds, you really need a minimum of 30 to minimize unsystematic risk. Not to mention that you’re getting a lot of international exposure, which might be too much for some people’s asset allocation. Just remember, there is no free lunch.
Hi anthony,
Thanks for taking the time to reply.
Also on reading the product details, it looks like for figuring out the coupon rate, first the auto cap of 7-10% and the floor rate of -30% applies at individual security level and then take a arithmetic average …so i guess it means that if a security does better than cap, only the cap will be taken for calculation and if it does really bad like -20%, then -20% will be taken for calculation……………….. give that i dont think i will ever see 7-10% unless everyone of the stock does really well
so i still dont understand why ppl invest in this product…..is it just ignorance?
Chitra: That is my understanding with regard to the coupon calculation as well. I think many investors take for granted whatever the banker or insurance agent says regarding MLCDs, and don’t really dig into the details. On its face, getting stock market returns and FDIC-insured principal sounds great, and I still believe there is class of investors that this might make sense for – I just don’t know who. At any rate, smart investors know how to allocate their funds congruent to their risk profile without the need for MLCDs.
I found this website while searching for more information on MLCDs. After reading these thoughtful posts, I thought I’d ask for some advice. I have $50,000 to invest from the sale of my home. I don’t believe I’ll need access to the money in the next 4-5 years (the earliest time I may purchase another house), and I am also not interested in a risky investment. After talking with an advisor at Wells Fargo, MLCDs were suggested as my best option. Any thoughts on what to do with this money would be greatly appreciated.
Heh, this article still LIIIIIIVVVEEESSS.
Gretchen: Do you have a term sheet for the offering from Wells Fargo? Many important details are spelled out in that document that will help you in your evaluation. Posting a URL would help us give you feedback.
Hi Anthony,
I just spoke with someone from Wells Fargo this am, and he said there isn’t any information on their website about this MLCD. He suggested investing most or all of the $50,000 in a 4 year MLCD which has no fees, and is mainly invested in 10 different commodities. There is no guaranteed return. It is a 1099 account and any pay outs will be held as cash in our account, which we can transfer to checking. He said if we’re willing to go with some of the money in low to moderate risk investments, he’d suggest we consider US. Gov securities funds which are low risk and avg. 5%/year. He also is suggesting their global bond fund, which is med. risk (he said 5 out of 10) but averages 10%/year. His suggestion is 40K in MLCD and 5K in each fund, or all in the MLCD, because he knows I might want to use this money to buy a house in 4 years. Any thoughts?
Thank you.
Gretchen
Gretchen: You bring up several points that raise red flags in my mind. First, I would not make an investment unless they can provide documentation that outlines the mechanics of this investment. This rep from WF can say whatever they want, but that document is what governs your relationship and the investment. Second, prices in the commodities market are highly volatile and would allow a lot of room for WF to calculate the returns in “creative” ways (i.e. not to your benefit). Next, those return figures seem quite optimistic to me. Even if they are true, past performance does not guarantee future results, and beware of reversion to the mean. Finally, the types of investments recommended for your time horizon seem terribly risky. I would not even put 4-year money in large-cap domestics, let alone in commodities or a global bond fund. Frankly, I think you need to be more concerned with return of your principle versus the return on your principle.
I’m not going to tell you not to invest in this MLCD. But, take your time and educate yourself about what you are getting yourself into – there is no rush. Visit http://www.bogleheads.org/wiki/Main_Page and read what you can. I will say that if it were me and my money, I would find a bank that offers CDs with the right to early withdrawal and choose the longest term CD available. I hope this helps.
Thanks, Anthony. I spent some time on the bogleheads website yesterday, and I’m going to leave the money in my savings account until I decide what the best option is. I appreciate your time and advice.
I’m getting pitched from Wells Fargo on MLCD Ladders and Market Linked Note Ladders. The sales person is pushing ‘protection of principle’, yet that only applies to one of the options, ie S&P 500 Index Note. She recommends putting only 14% of the required $100K minimum investment in this option. (by option I don’t mean put or call options) The other options have protection against the first 10% or 15% decline but have a 200% participation rate with a capped return of 37 to 42%. Still other options offer no principal protection. I’m retired and went thru the 2008 decline but made back a good portion of what I lost by rebalancing and walking around wringing my hands.
I’ve met with her on about 3-4 different occasions and gave her my information as far as investment statements and expenses. She filled out the ‘envision’ presentation and that’s how she came up with how my 100k should be split (more or less based on my risk tolerance). After reading as much as I can in the last couple days, especially, this blog, I find myself questioning this whole thing.
She gave an example of a capped scenario and I asked what happens to the remaining amount that goes above the cap and she couldn’t answer me. She assumed that nothing happens to it. I believe that’s one of the areas where the bank pockets their money. I’m also put off by the minimum. Last calendar year it was $50,000. Someone is cutting a fat hog. While the principal is supposedly protected, your upside earnings potential is also ‘protected’. I think I’m going to stick with Warren Buffets’ mantra; ‘don’t invest in what you don’t understand.’ Would welcome feedback. Thanks.
i am 60 been retired for 4 mos. am thinking about wells fargo marked lined certificates of deposits… what do you think.
So many of you have this wrong. You can’t compare market linked CDs to securities like index mutual funds, bonds, or anything like that. It’s a CD, not a long term retirement vehicle, for goodness sakes. Compare them to traditional CDs and that’s it. People have money in CDs to park the funds for a while, earn a little interest, and not lose the money. It’s just that simple. Some people in the past used them for income, but not any more, for the most part. Only the very risk averse see them as a long term retirement vehicle.
So, like traditional CDs, they are FDIC insured, guarantee the principal, and issued by banks. They just credit the interest differently. They are better for money (the principal) not needed for 5 or 6 years. You pay tax on interest earned each year just like a traditional CD. Nothing different here. Just take the interest earned and put it somewhere else. Or use it for income. A retiree could dump $200K in one of these for five years and earn some decent supplemental income, like the old days.
Don’t talk about long term capital gains and dividends. IT’S A CD… This is for people who want a CD. They know how it’s taxed. The main question is how much interest can I earn? That’s it. If they are looking at a traditional CD paying 2 or 2.5 percent interest for five years, they may say what’s the use. They would probably love the idea of making 10% on a CD instead of 2.5 percent.
Even if the interest paid is unknown from year to year, more than likely they will earn quite a bit more over 5 years than having the money in a traditional CD. And that’s as simple as it is. They can shop them, and find the ones that are the most flexible and have the best possibility of high returns, and go from there. Pure and simply put, they are a great alternative for the traditional CDs and will work well for many people.
I’m sorry Victor, but I’m not seeing how we have it wrong. Market-linked CDs differ substantially from traditional CDs in many ways, including:
- Traditional CDs have a stated rate that is guaranteed in almost every situation (except for bank failures, etc.). The rate on MLCDs is volatile and fluctuates with the underlying instruments.
- I can forecast the future interest earned for a traditional CD using a simple FV function in Excel. The interest on a MLCD isn’t known a priori, and most folks have a hard enough time deciphering the calculation from the offering documentation. I know, I’ve tried.
- With traditional CDs, you only pay taxes on the interest received. With an MLCD, you can be in a position where you have to pay taxes on an “imputed” interest amount and not have received a dime of interest.
Where are you pulling out that 10% figure? Actually, it doesn’t matter because the old adage still applies – past performance does not guarantee future results. When MLCDs track more than 10-12 securities (e.g. the HSBC offering linked above), then maybe I would feel like the label “market-linked” isn’t a misnomer.
Anthony- MLCD’s do differ from traditional treasury CD’s but still are Certificates of Deposit. Here are a few major changes and considerations I have not seen in the blog that may help future investors in deciding whether or not this is an appropriate option for SOME of their funds.
-Majority of issuers have corrected their tax treatment on annual income payments to a 1099 int. For instance…HSBC US Titans from June 10-June 11 paid 6.85% so on 100K you would receive a 1099 for $6,850. No more projected or OID tax treatment. If it returns 1.25% you pay tax on 1.25%.
-There are now many options offering a guaranteed minimum with a market average. Annual coupon of .50% plus market cap potential of 6% on top…this way in a down year at least you are earning a 0.50% which may or may not be competitive to a traditional 1 yr note. You can also opt for a higher market cap without a .50% guarantee.
-Strike price per stock is locked for term of the CD. Each anniversary the basket is looked at. If the stock is at the strike or higher, it automatically gets an “Auto Cap” of the 6%. For instance… let’s take Verizon. If Verizon locks at $37.00, as long as Verizon is at $37.00 or higher it is credited with 6%. Easiest way to figure your return is like a report card. Any of the stocks in the basket that are higher are automatically credited with 6%, subtract out the negatives, and divide by 12 for your coupon. Say 10 are up and 1 is down -8% and 1 is down -3%. (10 x 6 =60. 60-11=49. 49/12=4.08% plus the .50% if you chose that option)
-Strike price doesn’t change…Sticking with Verizon at 37.00. If next July Verizon is at 39, gets credited the “auto cap” of 6%. Verizon in July of 2013 moves to 43, gets credited the 6%. In July of 2014 Verizon retreats to 37.01. Even though Verizon was down -13.93% that year….Verizon is still at or higher than the original strike in July of 2011 so it gets credited with 6%.
Biggest thing to remember about Structured or Market Linked CD’s is to lower your expectations. It is not a mutual fund. It is there to compete with your safe money that is meant for a traditional CD. You are giving up an enormous amount of the upside for the FDIC insurance. Your risk is opportunity risk, not principal risk if held to maturity. Tax treatment is favorable now. Utilize this CD with other traditional notes, bonds, mutual funds, stocks, etf’s as you see fit but remember you are competing with CD returns because at its core it is still a CD. If you are ok with a return yearly between 0.50% with a max of say 7% on your safe money…it may be a good fit for you. I don’t like Well’s product. BNP Bank Of The West is decent. JP Morgan is Decent. I traditionally prefer the HSBC US Titans. Good product with a long history of performance. Also to answer where the difference of the percentage over the cap goes…. pretty much to the house. That’s like asking where the difference is when a bank lends at 4.5% on a note with your deposit and pays you 1.25%. Nobody ever asks. When you deposit into a CD it doesn’t sit behind the teller line. The bank figures out a way to utilize your capital to turn a profit whether it is in lending or by buying options on a basket of stocks. It still is FDIC insured and principal protected as long as held to maturity. Also, the bank doesn’t utilize all of your funds to buy options on the stock basket. Realistically, if you deposit 100K….the bank buys a zero coupon bond with about 85K that will grow back to the 100K in the 5 years. That is how they are protecting your funds and also why there is a penalty on early withdrawal. The remaining is used to create the Net Interest Margin. It is meant to be held to maturity like ANY cd. If you want all of the upside…then you also assume all of the downside. These products are new to investors but will be here for a long time and have been around for a long time. Expect many special interest groups to bash them as sales into MLCD’s last year were over 50 billion. You don’t think there are a number of fund companies or other groups dying to get that market share back.
- Hope this info helps a bit. Let me know if you have any questions guys.
An investment advisor at my bank, which isn’t Wells Fargo, just talked to me about structured cd’s. He’s selling the WF products. Do you know where I could go to get ones from BNP, JP Morgan, or HSBC?
Thanks Remy for the good info. I believe people will have a little better idea of what MLCDs are and how they work. I think it addresses some of Anthony’s comments. I think, Anthony, you’re over analyzing this making it more complicated than it needs to be. You know a lot of stuff, but’s it’s not for the typical CD buyer. You seem young so naturally you don’t want to use these. That’s fine. But for others, it would be good. To confuse people comparing them to securities and how you can make the same or better by trading options is not helpful because the vast majority of people won’t do that. Besides, maybe you’re not up to date on the MLCDs being offered these days.
Like Remy said, with a good MLCD, you pay interest on the income you earned that year and that’s it. And yes Anthony, there are still some MLCDs that may lock in at 10% or a little more as a cap. Most of the time it doesn’t happen, but it just depends and what it’s at when the CD issues. If it locks in at 7, 8, 9, 10, or whatever, it just means that each individual stock represented can pay you that cap that year. Some will and some won’t so you may get an average between the 10 stocks (if that’s how many are represented in the CD issued) of say 7%, or whatever. Heck, if all the stocks break even or are up that year, you can actually get the 10% on all of them so that your CD makes 10% that year, if that’s the cap. It does happen. Or you can get zero, or the minimum percent if you buy one with a minimum return. But as Remy said, this is safe money only. Mutual funds are securities and put your money at some risk. For people who like CDs and for those looking for decent returns with NO risk, MLCDs are a great option to look at. Held over a 5 to 7 year period, depending on the one you buy, chances are very good that the purchaser will experience a decent average return he/she will be happy with compared to traditional CDs, money market accounts, and savings accounts.
They’re not complicated. They’re FDIC insured, the principal is guaranteed, they are bank issued, and you have the opportunity to earn substantially more interest than a traditional CD over several years. You know going in that if you buy a 5 year MLCD, you leave your money there for the next five years, just like a regular CD. And if you pull it out prematurely, it could cost you, but not as much as some people may think. The main difference is how the interest in calculated. Your return is not guaranteed, only your principal. But if you have a 7% cap, you could make any where from 0 to 7% on any given year you own the CD. Will you hit 7% each year. Probably not. In a hot market over five years, probably. Will you get 0% each year. No. So if you average 5% over five years total return, is that better than your typical 1.50% 5 year CD. Heck yeah. The higher the cap, the better your average return. Six and seven year MLCDs have the highest caps.
There are many CD buyers that would like to have that opportunity to participate in the market’s growth within a CD and not have to worry about losing money. No complicated trading methods. No complicated investment decisions. Just buy the CD and make decent money. And those are the people who will buy these. Like Remy said, a ton of people are buying these and enjoying them.
I have a short power point on this that simplifies the explanation of this product. I may create a recording. If I do, I’ll post it here.
I think MLCDs have evolved over the past few years and while Anthony brought up some good points about the older products, they still worked as advertised, it’s just now the product is better.
I also think that Anthony and many others do not understand risk and the devastation it can do to one’s portfolio and investing behavior. It is one thing to experience a 30-50% drop when you have $50k at age 35 and quite another when you have $500k at 60.
MLCDs are an excellent investment for those with low risk tolerances, but desiring more than the 1-2% guaranteed rates in CDs. And don’t believe for a second that interest rates can’t go down even more or remain low for an extended time as mentioned in some of the earlier posts from 2009 and 2010; we are lower today and this is another example of not understanding risk.
The market is adapting to people’s desire to transfer risk with such products as equity indexed annuities, variable annuities with lifetime income guarantees, equity indexed universal life, protected principal mutual funds and MLCDs. All of these products protect either an investor’s principal and/or income from the negative risk of the stock market.
The world is larger than just bonds and indexed ETFs.
Paying taxes is a good problem to have – cause that means you are winning!! Making a decision on an investment based on taxes alone does not make sense.
Everyone wants great returns, liquidity, safety, insurance & not have to pay taxes. The reality is… it’s not out there. If you find an investment which carries all 5 compenents.. please let me know cuase I will put my life savings in it.
MLCDs are excellent for retirees who don’t need the income and are also good for parents savings for their children’s college tuition. If your chilld is 12 years and you have $20,000 saved for his college, I would consider 5 to 6 year MLCDs. Principle is protected with upside.
Yes, I know 529 plans give tax free benefits, but you usually have about 5 to 10 mutual funds to choose from in a 529 plan and principle is not protected.