Dear Dr. Don,
Please comment on investing in structured CDs and what the risks are.
-- Bette Cha
You're a woman of few words. There are so many different types of structured CDs that there's no way to know what you're considering.
Generally speaking, a structured CD derives its investment value based on the investment performance of some underlying asset. CDs that earn interest based on the performance of a stock index are one common example. Many structured CDs have a call feature allowing them to be called, paid off early, by the issuer.
This type of product becomes popular when the stock market is tanking -- like it is now. The attraction is that structured CD investors give away some of the upside potential they would have if they actually invested in the stock market for the assurance that they won't lose principal. Investors are often quite willing to give away some upside for that kind of guarantee.
Is it a good investment decision? Not usually. The financial institutions pricing the CDs are using sophisticated structures and pricing models that the typical retail investor doesn't fully understand. That gap in understanding can be expensive. Investors who wouldn't dream of buying options may be buying a CD chock full of those options.
The dividend yield associated with the underlying stock index is a good example of what the retail investor leaves on the table. It's common for a CD linked to a stock market index to exclude the index's dividend yield. Giving up that yield helps finance the hedges in the structured CD, but it's a reduction in yield from what you would earn when investing in the underlying stock index.
From my perspective, it is "buyer beware" when it comes to buying structured CDs. The call feature fits right in with that perspective. If you're in a winning position, the financial institution can call the CD away -- limiting your upside potential.
On the other hand, the financial institutions don't call away the underperforming CDs, so you're stuck with the underperforming asset. There are less expensive ways to hedge downside risk without limiting upside potential.
You've got your FDIC insurance but you've paid a price for that security. Is it worth the price? I'd get a second opinion before putting the money on deposit.