What is a Market-Linked CD?

Market-linked CDs — also called index- or equity-linked CDs — are often considered to be a kind of certificate of deposit (CD). Like other CDs, they earn interest on the deposited sum over a fixed period of time, but they are uniquely attractive to consumers because their rate of return is linked to the performance of a selected index, single security or a basket of securities.

Consumers discouraged by the low interest rates found among today's savings accounts and standard CDs have tuned in to banks that are advertising market-linked CDs. However, the complicated conditions and restrictions built into various parts of this CD type make it a risky proposition for all but the most dedicated and informed investors. For the most part, you will not lose out by selecting a straightforward fixed-rate CD of similar length.

Benefits of a Market-Linked CD

While consumer interest in market-linked CDs mostly focuses on their atypically high rates, banks also advertise their relative safety. As with regular certificates of deposit, the principal, or initial deposit in a market-linked CD, will never decrease in times of market downturns. This qualifies market-linked CDs as FDIC-insured deposit accounts, to a maximum of $250,000. As a result, there is no risk to the principal, so the whole product appears to offer the high returns of a market investment with the security of a standard bank deposit.

However, as with any financial product on the market, banks apply several restrictions to market-linked CDs that balance out their advantages. These can range from rules that cut back on the maximum market appreciation reflected in the CD to call options reserved by the issuing bank, which can redeem, or close out, the CD partway through its full term.

Market-Linked CD Fees

One of the key differences between market-linked CDs and more standard CD types is the potential for upfront fees. Sales commissions or deposit broker fees may come out of your initial CD deposit, diminishing your returns even before the behavior of the linked securities comes into play. Another fee to watch out for in the account disclosures is any type of annual fee, which is sometimes included to account for the ostensibly more complicated nature of market-linked CDs.

Calculating Return on Market-Linked CDs

Although every bank that offers market-linked CDs will require slightly different terms for its products, some of the common features you can expect will complicate the calculation of interest, usually with the purpose of mitigating the bank's risk by reducing the CD's potential earnings.

Participation Rate and Interest Caps

The most direct limit on a market-linked CD rate is its assigned participation rate, which determines how strongly the CD's interest rate follows its linked securities. For example, a participation rate of 75% with a linked index that grows 10% means that the market-linked CD grows by 7.5%, or 75% of 10%.

Another, more complicated limitation comes in the form of interest caps, which place a maximum on the potential growth of either an entire index or the individual securities which it includes. A cap of 5%, for instance, translates into a maximum of 5% growth on the CD — and combined with a participation rate, the final figure may be even less.

Interest rate caps on individual securities can prove even more disadvantageous. If each security that makes up the linked basket for the CD is capped individually, this means that the strongest performers will be limited in their impact. Additionally, because the rate "floors" meant to protect market-linked CDs from losses are rarely set as high as the caps on their gains, bad stocks will harm performance more than good stocks will help.

Take a theoretical market-linked CD that tracks a basket of two stocks, with a cap of 5% and a floor of 10% on each. If one stock does very well, growing by 20%, it will hit the interest rate cap and contribute 5% growth to the basket's average; however, if the other depreciates by 20%, the floor of 10% means that it contributes -10% to the average. Even though the true average change of the two stocks comes to zero — one up 20%, the other down 20% — the difference in the cap and floor would drive the basket's overall performance to -2.5%.

While a negative rate of growth on a linked security or index does not harm the principal, or initial deposit, of its market-linked CD, the resultant return of zero can be considered a loss given the opportunity cost of not investing the same money in a fixed-rate CD, which gains earnings at a constant rate for its entire term.

Average Appreciation vs. Point-to-Point Return

The basic arithmetic used to calculate the return on market-linked CDs follows two general structures. Average appreciation is the average of the linked index or security values at several predetermined "observation points" found at regular intervals in the lifetime of the CD. This means that the final figure for the CD's rate of return is affected by the history of the index's value instead of the total difference. Point-to-point return measures only the difference between the initial value and the final value just prior to maturity.

For example, if a market-linked CD's index stands at 10,000 points and grows to 20,000 over 5 years, the point-to-point return would be 10,000 points, a return of 100%. This is true no matter how the index behaves prior to reaching 20,000 points. However, the average appreciation of the index is calculated by taking the average of index values at all observation points along the way.

Linear GrowthLate GrowthEarly Growth
Initial Value 10,000 10,000 10,000
Year 1 12,000 10,250 15,250
Year 2 14,000 10,750 18,250
Year 3 16,000 11,750 19,250
Year 4 18,000 14,750 19,750
Year 5 20,000 20,000 20,000
Average Appreciation60%35%85%

If this index grows in linear fashion, the sum of the observation points is 80,000; divided by 5, that produces an average appreciation of 16,000. This comes out to a 60% growth rate, but the figure changes significantly based on the observation points: if the index experiences very slow growth for most of the term, only to see rapid growth late in the term, then the average appreciation will decrease, since 67,500 divided by 5 is 13,500, or 35% growth. Conversely, if the index has rapid early growth, but slows down over the remainder of the term, the average appreciation will be higher, at 85%.

Graph of three possible growth curves for an index

Unfortunately, the term "average appreciation" is often used to disguise the fact that the final figure will always be lower than the point-to-point return. And while market-linked CDs are guaranteed against loss of your principal (the initial deposit), the linking of interest rate to market performance makes it possible to earn zero interest during parts of the term. Once again, this represents a significant opportunity cost compared to the reliable return possible on a fixed-rate CD in the same time period.

Call Features

Sometimes, banks that offer market-linked certificates will include a call feature that allows them to redeem the CD before the end of its term. Calling a CD early requires the bank to return the customer's full deposit along with any interest earned up to that point, but the certificate holder loses out on the potential income the CD would have earned up to the final maturity date. Banks will usually exercise a call option in response to a decline in interest rates, as it becomes cheaper to borrow money at the new rate compared to the rate fixed on the CD.

While market-linked CDs are not the only type of certificate that can carry a call feature, they are especially vulnerable to calls because of their constantly shifting rates, which move in conjunction to securities. If the linked index is performing better than expected, resulting in a strong CD rate, the bank may consider calling the CD sooner rather than later in order to cut its losses. This makes it essential to note whether your CD can be called, as well as the minimum length of time that must pass before the call can be exercised.