Key Takeaways
- An equity-linked certificate of deposit is a time deposit that accrues interest based on the performance of a stock market index, such as the S&P 500.
- Generally, equity-linked CDs are issued with multi-year terms, whereas some traditional CDs have terms as short as one month.
- Equity-linked CDs can be relatively high-yielding; however, after factoring in fees, participation rates and interest rate caps, many of these instruments underperform compared to traditional CDs.
- Equity-linked CD terms vary widely from one financial institution to the next.
What Is an Equity-Linked CD?
An equity-linked CD is a type of CD that accrues interest based on the performance of a stock market index, such as the S&P 500 or NASDAQ Composite Index. With an equity-linked CD, you could earn a relatively high yield, but you could just as easily earn a relatively low yield.
Some equity-linked CDs guarantee a minimum rate of return, but this is not the case for all products. With some, you can lose money.
This is very different from a traditional certificate of deposit (CD), which offers a guaranteed, fixed rate of interest. A traditional CD is a type of savings account offered by most deposit-seeking financial institutions. In exchange for a commitment to leave funds on deposit for a specified period, a traditional CD offers an accountholder a guaranteed rate of interest. However, early withdrawal triggers a loss-of-interest penalty.
Usually, traditional CDs have a maturity date that falls somewhere between one month and five years. Equity-linked CDs have multi-year terms.
How Does an Equity-Linked CD Work?
The process for investing in an equity-linked CD begins the same way as the opening of a traditional CD. You are required to apply in-person or online with the issuing financial institution. These days, online application is the most efficient approach.
After providing pertinent personal information and depositing your funds, the CD account will be opened and in-force for a specified term. Generally, to avoid a loss-of-interest penalty, you must keep the funds on deposit for the entire period.
Let’s flesh-out the nuances of an equity-linked CD with an example.
Consider the following scenario:
- You buy a $10,000.00 equity-linked CD on Jan. 1, 2023.
- The term is five years (maturity on Jan. 1, 2028), and interest is credited annually based on the point-to-point performance of the S&P 500 on Jan. 1.
- The contract specifies an annual participation rate of 70%, an interest rate cap of 15% and a floor of 0%. Essentially, this ensures your gross return will fall somewhere between 0% and 15% each year.
- The contract also specifies an annual administration fee of 0.25%, which is to be deducted from your gross returns.
- Net interest is compounded annually, and all payouts are made at maturity.
Over the five-year term, the S&P 500’s performance and your annual interest credits are as follows:
| Anniversary Year | Measurement Date | S&P 500 Close | S&P 500 Return % | Gross Interest Credit | Net Interest Credit |
|---|---|---|---|---|---|
| 01/01/23 | 3,850.00 | n/a | n/a | n/a | |
| 1 | 01/01/24 | 4,750.00 | 23.38% | 15.00% | 14.75% |
| 2 | 01/01/25 | 5,000.00 | 5.26% | 3.68% | 3.43% |
| 3 | 01/01/26 | 4,100.00 | -18.00% | 0.00% | -0.25% |
| 4 | 01/01/27 | 4,400.00 | 7.32% | 5.12% | 4.87% |
| 5 | 01/01/28 | 4,700.00 | 6.82% | 4.77% | 4.52% |
At maturity, your payout is $12,977.76, which reflects an annual percentage yield (APY) of 5.35%. The payout computation is as follows.
Equity-Linked CD Maturity Payout = Principal Balance × (1 + Y1 Net Credit) × (1 + Y2 Net Credit) × (1 + Y3 Net Credit) × (1 + Y4 Net Credit) × (1 + Y5 Net Credit)
Equity-Linked CD Maturity Payout = $10,000.00 × (1.1475) × (1.0343) × (0.975) × (1.0487) × (1.0452) = $12,977.76
Many equity-linked CDs contain a call feature, which gives the issuer the right, but not the obligation, to redeem the CD prior to maturity. Generally, this feature will be exercised when the issuer anticipates an opportunity to minimize the amount of interest it is paying out on an investment.
Equity-Linked CDs vs. Traditional CDs
Beyond the interest accrual difference described above, there are a few other important distinctions between equity-linked CDs and traditional CDs.
3 Differences Between Equity-Linked and Traditional CDs
- Equity-linked CDs do not offer short-term tenures while traditional CDs have terms as short as one month. Equity-linked CDs have multi-year terms.
- The minimum deposit requirements for equity-linked CDs are usually higher than those associated with traditional CDs.
- Equity-linked CDs usually have ongoing administrative fees while traditional CDs seldom levy such charges. Both types of CDs have early-withdrawal penalties.
Pros and Cons of Equity-Linked CDs
On the surface, a certificate of deposit is a very safe investment. When structured properly, it is fully ensured up to $250,000 for an individual account and $500,000 for a joint account. Bank CDs are insured by the Federal Deposit Insurance Corporation (FDIC), and credit union CDs are insured by the National Credit Union Administration (NCUA).
However, CDs are inherently illiquid and subject to early withdrawal penalties. CDs are also exposed to inflation risk, which is the possibility of experiencing diminished purchasing power due to a marked rise in the prices of goods and services.
Equity-linked CDs are exposed to yet another risk – market volatility. Unlike a traditional CD where you know what you are getting, an equity-linked CD could generate above-average income or below-average income, depending on the performance of the underlying index.
Many equity-linked CDs offer a minimum rate of return, but this is not always the case. In fact, some CDs expose you to the potential for loss of principal. The loss can be magnified by the incurrence of costly administrative fees.
Is an Equity-Linked CD Right for You?
Equity-linked CDs are best suited for long-term investors looking to participate in the upside of equity markets without exposing themselves to downside losses. In many ways, they are like indexed annuities.
That’s because equity-linked CDs have a completely different risk profile than traditional CDs. They exhibit a higher degree of year-over-year volatility, and they can expose you to financial loss. While some products offer downside protections, these instruments should never be viewed as stable-value investments.
If you are considering purchasing an equity-linked CD or an indexed annuity, then consider consulting with a reputable financial advisor — ideally, a fiduciary. They can help you holistically assess your options.
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