For folks who believe stocks may be headed up, but are still shellshocked by the Wall Street collapse of 2008, an indexed certificate of deposit may offer a chance to participate in the market while protecting your principal if the Dow and Standard & Poor's head south.
At the same time, indexed CDs carry their own set of risks for consumers -- so investors need to consider all aspects of a deal before handing over their money.
Indexed CDs are simple in theory. Basically, they are CDs whose return is indexed to something. Typically, they are indexed to a stock index -- the Dow Jones Industrial Average, for instance, or the S&P 500. But they can be indexed to any number of things -- bonds, currencies or commodities prices, for example.
They are offered by banks, which means they have FDIC insurance up to $250,000, and they are often sold by financial advisers.
"Indexed CDs frequently offer higher yields than Treasury securities, and that, combined with FDIC insurance, is very attractive to investors who are concerned with managing the downside risk in their portfolios," says Chris Geczy, director of the Wharton Wealth Management Initiative at the University of Pennsylvania.
Indexed CDs differ from the traditional variety primarily in how the return is calculated. Most CDs have a set term and set interest rate.
However, an indexed CD's yield is largely determined by the performance of the index it's linked to. If it is tied to the S&P 500, for instance, and that index rises, you will receive at least part of that increase as a return. If it falls, you get little or no interest but your principal is protected.
It's the kind of investment that could have protected investors in 2008, Geczy says. "And investors might want to hold it now, as so many who suffered catastrophic losses may not be able to stand another such experience."
But beware of the complexities of your indexed CD. For instance, with a regular CD you could liquidate it before maturity and get your principal back, although you would likely forfeit accrued interest.
If you terminate an indexed CD early, there's no guarantee your full principal will be returned.
Also, the way returns are calculated can vary widely. An indexed CD might offer you a one-to-one return on your index's appreciation, but only up to a point. As an example, it might match the S&P's gain up to 70 percent. At that point, you might no longer receive more interest.
In addition, there are wide variations in the so-called participation rate. For instance, with a participation rate of 75 percent, you would receive a return of 7.5 percent if the index rises 10 percent. Participation rates can vary from CD to CD.
Be aware that how the index's gains or losses are calculated will affect your return. The simplest way is point-to-point, which looks at the index value at the beginning and end of your CD term.