How market-linked CDs workArticle added by Stephanie Marchant on March 19, 2012
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The protection of invested principal with financial market exposure is what makes MLCDs an innovative and increasingly accepted product among investors and depositors alike.
A market-linked CD is a product based on one or more underlying asset classes, such as a basket of securities or market indices. The structure of a MLCD allows the purchaser to participate in the growth of the underlying asset class while retaining the characteristics of a traditional certificate of deposit, including protection against market decline.
When held to maturity, a MLCD's principal is protected with the purchaser receiving interest based on the performance of the underlying asset class during the term of the CD or on the redemption date. If the CD is redeemed prior to maturity, the principal will not be protected and the purchaser may realize a loss, even if the underlying asset has appreciated.
Who should purchase market linked CDs?
The development of MLCD came from the increasing demand of clients willing to limit their upside performance in order to protect their principal investment.
While anyone can purchase MLCDs, purchasers are commonly looking to secure their wealth and benefit from market growth while receiving protection from possible declines. Young families, conservative investors, families saving for college, baby boomers and retirees are examples of those who may choose to address these objectives by purchasing market linked CDs.
As an alternative investment product, MLCDs can complement an overall balanced portfolio while offering the potential to realize enhanced returns compared to traditional savings or deposit options.
MLCDs have the potential to earn greater returns than traditional fixed income instruments over the same duration. This performance is generated by the assets the CD is linked to and the payoff structure used. MLCDs can be designed for growth strategies, income strategies or a combination of both.
MLCDs provide the potential for capital appreciation based on the performance of an underlying asset or basket of assets with complete protection of the original deposit, when held to maturity. When issued by an FDIC insured bank, the FDIC insures the original deposit if the issuing bank becomes insolvent. The FDIC standard maximum deposit insurance amount is $250,000 per depositor per FDIC insured institution.
Asset class: MLCDs can be linked to a wide variety of underlying asset classes such as equities, commodities, currencies, market indices, fixed income, inflation and more.
Geography: Exposure can be provided to foreign and emerging markets without the additional currency risks of direct market investment.
Sophistication: MLCDs can be structured with various levels of complexity to accommodate specific investment needs that could be difficult to replicate by independent investors.
Changing the status quo
MLCDs have been developed due to demands from both investors and depositors as they searched through traditional investment and deposit products to suit their needs in today’s markets. While the balance between risk and reward has always been a mutual challenge, MLCDs may bridge the gap between both worlds. The protection of invested principal with financial market exposure is what makes MLCDs an innovative and increasingly accepted product among investors and depositors alike.
Market Linked CDs combine the upside potential of investing in the financial markets with the safety of a certificate of deposit.
Like all investments or deposits, clients should review all of the risks associated with that specific deposit or investment. MLCDs should be considered as a part of a balanced portfolio. The following risks may apply: performance/ market risk, liquidity risk, costs and tax treatment.
In addition, although MLCDs are FDIC insured, any purchase greater than the limits set by the FDIC will be subject to the credit risk of the issuer.
The performance of MLCDs is based on the performance of the underlying asset(s) with respect to the type of payoff structure. Generally, a MLCD’s posessive performance may be less than investing directly in the same underlying asset(s). Clients run the risk of underperforming a traditional fixed income instrument if the asset(s) used to determine the performance of the MLCD devalue over the life of the CD.
Market Linked CDs do not trade on a secondary market and can only be redeemed prior to maturity if the issuer is able to unwind the CD early. Clients should purchase market linked CDs with the intent to hold the CD till maturity.
Market linked CDs may be subject to different tax treatments that are based upon the type of structure. Clients should review the offering document in order to determine what type of tax liabilities the holder may be responsible for annually. The client typically does not have tax liabilities if purchased in a qualified account like an IRA. \
Clients selling back their CD prior to maturity can realize some of the built in costs that were created when constructing the MLCD like hedging costs, placement fees, and breakage fees. These costs are likely to adversely affect the price at which the client can liquidate their CD prior to maturity.
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