In an economic environment in which many investors have opted out of the market, “structured” investments that promise investors upside but guarantee against losses have gained in appeal, and sales of the products have skyrocketed since 2007.
But a new consumer alert from the FDIC on market-linked CDs, one of the most popular structured products, counsels investors not to let the possibility of higher returns obscure their view of the risks.
Government consumer alerts are a genre unto themselves in that it is hard not to come away from them without thinking the product described is a very bad thing indeed, sold by Snidely Whiplash after he has tied his own mother to the train tracks. But it is a useful service nevertheless, helping investors know what risks to look out for.
Market-linked CDs, also known as indexed, structured or equity-linked CDs, are certificates of deposit that are tied to a variety of indexes, including the S&P 500, the Dow Jones Industrial Average, bond indexes, global indexes, currencies and other risk assets. Barclays Capital and DWS Investments are among a number of product providers active in this market.
The FDIC suggests a number of factors investors should consider before entering a contract to purchase these products, starting with the most basic: Is the principal really guaranteed against loss? While consumers associate CDs with FDIC protection, and these bank products are generally guaranteed, the absence of such a guarantee means the FDIC will not protect an investor in the event of a bank failure.
The CD’s maturity is another key factor. CD investors are used to short maturities of 3 months to 5 years, but market-linked CDs can be 10- or 20-year affairs. Yet these products are often marketed, aggressively, to seniors with shorter time horizons.
CD investors are also accustomed to early withdrawal penalties, but should be on guard for provisions that disallow any early withdrawal. While the contracts may allow exceptions for heirs in the event of the depositor’s death, consumers—seniors particularly—should pay attention to those details in the contract’s fine print. Sales on a secondary market may provide another exit possibility, but the FDIC warns consumers to consider that such a sale may be at a loss (if current rates are higher than the depositor’s rates). The broker’s sale might also incur a commission.
Another important reason to read the fine print is the necessity of understanding the formula a market-linked CD uses to determine an investor’s upside. Just as these products have downside guarantees, so too do they have upside ceilings.
The FDIC alert quotes its Consumer Affairs Specialist Meron Wondwosen saying, “You may find that your share of any uptick in an index will be limited to a certain percentage and subject to a maximum cap. For example, it’s possible for the market index to increase by 25% but your actual return on the CD may be only 10%.”
Another concern with market-linked CDs is “phantom income” in situations where investors get a tax bill each year on interest earned, even where the interest is not accrued until the CD matures. Surprisingly, the consumer alert, chock full of warnings, does not emphasize that though these products are equity-linked, they are definitely treated, unfavorably, as fixed-income products for tax purposes (rather than incurring the lower capital gains tax rate on stocks).
But here’s where the FDIC alert gets scary. The phantom income problem may be as nothing, literally, since some of these products pay no interest at all, though that is generally expected of CDs. But even that is a trivial concern if your bank fails and the CD accrues interest only upon maturity. In that case, the FDIC will cover the principal amount, but not pay the interest, since it never accrued.
Perhaps the biggest red flag investors must be mindful of is that market-linked CDs often have “call” features, allowing the bank (but not the depositor) to close the contract with no penalty, paying back principal and any accrued interest.
“The bank is most likely to exercise this option when interest rates fall, which means a callable CD would limit your ability to lock in an attractive interest rate for a long time,” the FDIC warns.