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Index CD may boost returns but add risk

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Think that CDs are plain vanilla investments?

Think again. Low CD rates are pushing consumers to think outside the traditional CD box. The result is that a CD that is linked to currencies, stock indexes or commodities is increasingly gaining traction.

Called an index CD, its main appeal is that it’s linked to an index that can potentially boost returns by participating in market rises. So, say you have a five-year CD that’s linked to the S&P 500. If it goes up 30 percent during that time, investors can cash in on that growth when they redeem their CD.

“People do have to grow their money,” says John Rhett, chairman of SunTrust Investment Services in Atlanta, who has seen surging interest in his company’s index CDs. “They’re sitting on nearly zero percent interest rates. So they’re willing to take more risks.”

Firms like Wells Fargo and JPMorgan Chase offer CDs linked to baskets of stocks and commodities. And there are also CDs linked to the S&P 500 or Dow Jones industrial average at Union Bank, based in San Francisco, which began offering index CDs in the past year. “You can make a CD linked to almost anything that has a daily price,” says Rhett.

The trick is to understand these complex investments, since there are lots of quirks: short offering windows, varying pricing structures and differing caps on upside potential.

“Each company has its own structure,” says J. Scott Miller, managing partner at Blue Bell Private Wealth Management in Pennsylvania. Fees even vary, he says. Given the many twists and turns, regulators are looking very closely at these CDs, say experts.

Miller says that many index CDs are too complicated for average investors to understand, model and predict returns. “Make sure you understand exactly how they work,” Miller says. Some catches aren’t evident in sales pitches. “How is your profit calculated?” he says.

Other experts add that these CDs are virtually illiquid. There’s no secondary market and you’re penalized for early withdrawals. That’s why they are strictly buy-and-hold investments.

Also, hybrid CDs come and go. Gold-linked CDs were offered by JPMorgan and EverBank during the financial meltdown. But they were eventually pulled because they were expensive for investment firms to offer. “But the investors that bought them are doing fabulously,” says Chuck Butler, president of EverBank World Markets. Currently, SunTrust offers a gold-linked CD through its brokerage arm.

Still, they are suitable for some conservative investors who are strictly buy and hold but want to diversify their portfolios. Here are some index CDs worth looking into.

Currency CDs. EverBank presently offers short-term world currency CDs for over 20 countries. Essentially, you’re scouring the world for the best interest rates, says Butler.

Investors can choose how the investments are structured: single currency, index CDs in a basket or short positions. Currently more than $1 billion is invested in EverBank’s entire cache of index CDs.

Investors reap profits in two ways: earning interest and currency gains. For example, Australian CDs pay 3 percent annually, but also had 30 percent currency gains last year. So if you buy a one-year CD, you get the 3 percent interest along with the currency gain when you convert it into American dollars at the end of the year. You do pay a fee to convert your foreign currency CDs into dollars, though.

Investors are currently investing in the Norwegian krone, Brazilian real and Canadian dollar, Butler adds.

“The upside is that you’re making sure you’re properly diversified,” says Butler. “Also, you have insurance against further declines in the dollar.”

Beware the downside, though. If your currency-linked CD sinks in value against the dollar, then you can lose principal. “You could lose all your principal,” says Butler. “But we haven’t seen that happen.”

Gold-linked CDs. SunTrust currently offers a five-year CD that’s point-to-point. That means if you buy the CD on Jan. 20, 2010, when gold is, say, $1,100 an ounce, and you redeem it on Jan. 20, 2015, your return is the price of gold that day. So, if gold soars to $2,000 an ounce during that time, but collapses on Jan. 20, 2015, you only get the price that day. Also, these CDs don’t pay interest.

Even so, Miller believes that point-to-point CDs are a better choice than averaged CDs, where payouts are annual.

And these CDs make sense for those who want FDIC protection on their investments and think gold will rise, say experts. Returns are capped at a hefty 80 percent. SunTrust clients have snapped up these index CDs. In 2009, SunTrust sold $800 million in these CDs, versus $500 million in 2008.

However, Rhett and some other experts would rather own gold itself. “You get higher returns if you just buy gold,” says Miller. “If you really think that gold is going up, you’re forgoing participation.”

SunTrust also offers CDs linked to the S&P 500 for investors who want to cash in on rising equities.

“You shouldn’t be enticed by the potential upside,” says Miller, “but by safety. If the index-linked CD is too complicated, avoid it.”