Indexed CDs offer investor protections, risks

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.

But sometimes the index performance is measured using other methods, such as looking at the averages from each quarter. The method of computation can either raise or lower your return compared to point-by-point measuring.

“That’s something I’d immediately look at,” says John Largent, chief investment strategist at Members Trust Co. in Tampa, Fla. “People might not get the equity participation they think they are.”

Justin Capetola, a managing partner at Blue Bell Private Wealth Management in Blue Bell, Pa., says consumers should be able to find a matching return on an index up to 45 percent or so. He recently offered his clients five-year indexed CDs that pay no interest and match the Dow’s return up to 47.8 percent.

“These clients want to be safe, but they still want to have some chance for market participation over the next five years,” he says.

Other risks remain. Some indexed CDs have a “knockout” rate, which sends the return back to zero if the index soars too high. In such cases, “you’re really making a bet about market volatility — that the market will stay in a range,” Geczy says.

Two other areas to watch out for: taxes and fees.

Typically, a bank issuing the CD will hedge against the potential cost of making a payout to you. It will pass along the cost of that hedging contract to you. Similarly, a financial adviser may charge a fee of roughly 3 percent of your investment.

As for taxes, earnings are taxed like a normal CD’s interest payments, and you may be taxed for paper income you haven’t yet received. You might consider putting it in an IRA account, which can build wealth tax-free, to avoid this issue.

Finally, find out if the issuer has the right to call your CD, as bond issuers do.

“All this just underscores the importance of shopping around and reading the fine print,” says Geczy. “This isn’t like just going in and buying a CD. Investors should understand the parameters of these investments and how they might change in different market environments.”