Are Market Linked CDs a Good Investment?
Last week I was reviewing a market-linked CD that a client had purchased. He didn’t quite understand how the product worked and wasn’t sure if he made a bad choice when he invested in it. With interest rates so low, this type of structured product has been increasing in popularity so I thought I’d share some thoughts here.
A market linked certificate of deposit is a savings & investment product being sold by many banks that provides a guaranteed rate of return with the possibility of a higher return based on the performance of the stock market. These products appeal to investors who need safety, but want to earn more than what traditional CDs are currently offering.
Are they worth while investments? Before I suggest alternatives, let me point out a couple key considerations to keep in mind.
- There is normally a hefty penalty if you cash out of the CD before it fully matures.
- Your guaranteed interest rate is typically lower than the guaranteed interest rate on a traditional CD with the same maturity.
- As with most equity-linked products, the upside is limited. The stock portion of your investment might rise 60%, but you may only capture 40% of it.
- The returns on the CD will be paid as interest, which is likely taxed at a higher rate than long-term capital gains.
- You will not collect any dividends on the stock portion of your investment.
Every market-linked CD is different and should be evaluated on its own. While the numbers and equity links may differ across products, the particular CD I was reviewing is fairly typical in its behavior.
Duration: 5 Years
Guaranteed Interest Rate: 0.5%
Performance Event: 3% additional interest contingent upon the closing prices of all stocks in the underlying basket being equal to or higher than their price when the CD was purchased. Calculated annually, with “memory”.
Basket: Apple (AAPL), Coca-Cola (KO), General Electric (GE), McDonald’s (MCD), Procter & Gamble (PG)
Summary: Investor receives 0.5% guaranteed growth with the possibility of 3.5% annual growth if 5 years from now, the price of every stock in the basket is equal to or higher than its price today. The performance event is monitored annually and there is “memory”, meaning, regardless of where price trades in previous years, once the condition is met, all back interest is paid (i.e. if prices are higher in 5 years, investor receives 3.5% interest annually).
When deciding how to invest money it is important to weigh options and alternatives. The main objective of this type of investment is capital preservation, so that is not something we can negotiate on. At the end of the investment period, the investor should be returned at least their initial investment amount. The secondary objective is capital appreciation, which is what we will debate.
Assume an investor has $38,000 to invest.
Option 1: Market Linked CD
Invest $38,000 in Market Linked CD.
I backtested the possible returns for this CD based on the closing prices of the five stocks all the way back to 1981. The returns are based on rolling five year periods (monthly data) starting in December of 1980 (Apple IPO) and ending in January of 2016 (last closed return period would be January 2011).
I am making no assumptions about future expected returns for the stock market. The goal of the exercise is to point out simple probabilities based on price history. Also, rates on 5 year CDs were very different throughout the backtest period but all results are assuming current 5 year CD rates of 2%.
Based historical probabilities, an investor in this product has an expected return of 2.63% annually or 13.9% on their total investment after five years. Keep in mind, this not a guaranteed return. The investor is only guaranteed a return of 0.5% per annum or 2.53% on their investment. Expected return takes into account probabilities of past returns (i.e. on average, investors have typically seen this type of return during the backtest period).
Option 2: Traditional CD
How will the investor fair if they choose to invest $38,000 in traditional 5-year CD yielding 2%? This option provides the investor with a higher guaranteed yield but without the possibility of further upside by participating in stock appreciation.
The investor is guaranteed to return 2% annually which is 10.41% appreciation of their total investment after five years.
Option 3: Traditional CD + Equity Investment
A third option would be a more self-directed investment approach by splitting up the initial $38,000 investment. The investor could invest $34,418 in traditional 5-year CD yielding 2%, and the remaining $3,582 in an equal weighted portfolio of the five basket stocks (AAPL, GE, KO, MCD, PG).
By investing $34,418 in a traditional 5-year CD yielding 2%, the investor is guaranteed to have at least $38,000 in five years (their initial investment amount).
Here the numbers get interesting. You can see that since 1981, almost 90% of the time, holding this basket of stocks for a five year period will generate greater than a 50% return on your equity investment. The minimum return has been -1.54% (purchase in March 1998) and the maximum was a whopping 535% (purchase in September 2002).
With this option, the investor’s guaranteed return is 0%. Although it is highly unlikely, if every stock in the basket goes to zero, the investor would lose their entire equity investment and be left with their initial $38,000.
Based on history however, 90% of the time the investor would have seen greater than a 50% gain on the equity portfolio which would make the minimum return on the total initial investment 14.14%.
What if we price in some type of reasonable disaster? Let’s say every stock in the basket lost 50% of its value in five years. That would leave the investor his initial $38,000 from the CD + $1,791 in equity for a total of $39,791. This equates to a 0.93% annual growth rate or 4.7% return on the initial investment. Not great, but certainly not terrible.
Deal or No Deal
So what do we make of all this? All three options meet the main objective of capital preservation where the investor is returned all of the initial investment amount.
The market-linked CD seems to provide the investor with market participation, but nearly 40% of the time the investor would have been better off had they chosen a traditional 5 year CD.
If the investor truly wants the possibility of participating in market returns, option three seems to be most favorable. Direct investment in equities leaves the upside uncapped and the history of returns over five year periods has been strong.
With the market-linked CD, 65% of the time an investor has seen a total return greater than 14%. Their maximum return over a five year period is capped at 18.77%. Their minimum return over a five year period would be 2.53%.
Historically, 89% of the time a self-directed investor choosing option 3 has seen a total return of greater than 14%. Since 1981, the investor’s maximum return over a five-year period was 59.9% and their minimum return was 9.28%. Their upside is not capped while there is a very small possibility the strategy returns 0%.
When it comes to decisions like this, there is no doubt that convenience plays a role. Most investors don’t figure out the probabilities of their returns or care to invest directly in stocks on their own. They don’t have the time, desire or knowledge to do so. They go to the bank, have a “financial advisor” (sales guy) tell them they should buy a market-linked CD and not knowing any better, they do.
A market-linked CD sounds wonderful but as with most structured products, I remain largely skeptical. I think most investors interested in capital preservation and yield would be better served by either of the alternatives I outlined above. Don’t expect the “advisors” at your bank to walk you through these options though. Presenting this type of analysis just gets in the way of their sales process 😉