At IAVG, we’re excited about Equity Linked CD’s.  We view them as life-style changers.  These are CD’s put together by banks, so they are FDIC insured. 

What the banks do is they structure these CD’s in order to simulate stock market performance.  So, let’s say that you buy a CD linked to the S&P.  If the S&P goes up over the period of the CD’s term, the investor gets some or all of that performance.

Q: What does it you mean some or all of the performance?

A: Sometimes the bank can’t manage to replicate the exact performance but they can create a 50% or sometimes a 75% correlation to the S&P.  So if the S&P gains 60% over the period of the CD the investor would expect to receive a 30% gain in his CD.

Q: What if the S&P takes a 40% loss?

A:  That is actually good news for the investor.  The investor now has 100% of his principal and is ready to roll that money into a new CD FDIC insured against loss.  Also, no that the market has declined by 40%  All that needs to happen for the investor to receive a significant gain is for the S&P to regain half of what it lost (that would be a 20% of the original value but 33% of the low value.  Remember, if you loose half of your money in an individual stock, that stock would have to DOUBLE to make your position even.  Indexed CD’s take great advantage of this calculation.

Q: What you’re saying is that because the investor only participates in positive periods and receives all his money back after negative periods, he may get ahead of investors who are more of risk takers?  Isn’t there the old saying “Risk vs Reward, the greater the risk the greater the reward?”

A: That’s true to an extent, but by using these equity linked CD’s in a strategic way, a client can reduce risk and may come close or even ahead of stock market performance.

Q: This seems so simple where is the downside?

A: One downside is that the CD’s must be held to maturity in order to receive the FDIC insured. 

Q: What will happen if the Investor needed to sell a CD before maturity?  Would he incur great losses?

A: The CD would have to be sold on a secondary market.  This means that the investor would receive what other investors would be willing to pay him for it. 

Q: What would that be?

A:  Let’s say you bought a CD based on the S&P 3 years ago and it another 2 years to maturity.  Well, the S&P was about 1500 then and it’s about 900 now.  Since no one believes that the S&P will be worth 1500 in two years, most people would be willing to pay 92 to 95 cents on the dollar for this CD.

If an investor would walk into the bank he could receive a CD yielding about 2.5%.  So by paying 95 cents and making 2.5% you get back to a dollar in 2 years. Since the CD is FDIC insured, by waiting 2 years the investor would receive his full dollar.  I said 92 to 95 cents on the dollar because the typical investor wont search out such an investment to make 2.5%, he’d probably go to the bank and buy a regular CD—so the effective yield may be closed to 4% over two years.

On the other hand, if an investor would buy a CD now when the S&P is at about 900 and the S&P almost doubled and returned to the 1500 level.  This investor would possible be able to sell his CD for a profit on the secondary market.  It would still be at a discount compared to if it were to mature the same day as you sold it—because the buyer has to worry if the S&P will fall after the buys it.

Q: Why don’t these CD’s yield a certain amount regardless of market performance? 

A: The bank makes the assumption that the investor wants a simulation of stock market performance in lieu of the typical yield that a CD pays.  In fact, that’s how Equity Linked CD’s are created.  The Bank takes the (lets say hypothetically) 5% yield that it would have paid to investor over lets say a 5 year period.  The Bank puts that yield to work through buying institutionally priced options on the particular index that the CD is linked to.  So the investor can receives stock market performance if the stock market creates gains; and investors receive 0% performance if the stock market creates losses.

Just a word on FDIC insurance.  When you buy  a CD from a bank, lets say with a 5% yield for five years for a total gain of 25%, the bank is responsible to pay you that 25% return plus principal and should the bank fail, the FDIC is only obligated to pay the principal.  The same is true with these equity linked CDs, the bank is responsible to pay the client the gain.  Of course the bank has already created institutionally priced derivatives and has those funds set aside to pay the investor at maturity. 

Q: What are the tax ramifications of an Equity Linked CD

A: Gains will be taxed as income at maturity.  A client told me once “that’s great, I pay the taxes once then I don’t have to worry paying taxes as I withdraw income.”

Some things to know about how an Equity Linked CD works:

• The principal amount is not guaranteed if the CDs are not held to maturity.

• There may not be an active secondary trading market in the CDs.  This means that if you don’t wait for the maturity date, you may only be able to sell the CD for a reduced price.  This is why the issuing banks want investors to understand that Equity Linked CDs should be viewed as long term investments. 

• Payment of the principal amount, and any Final Return is the obligation of the Issuer and subject to the Issuer’s ability to pay obligations as they come due from its assets and earnings.  The FDIC only insures banks on the principal, any gain on principal is not necessarily insured by the FDIC but the Issuing Bank.
{However, unlike insurance carriers, where the backing of the guarantees comes from their cash reserves, with indexed CD’s the Issuing bank has structured the CD with financial instruments [derivatives] that mimic stock market performance.  So, if there is a large payment above principal the bank is not surprised and has planned for that.}

• Return on the CDs do not necessarily reflect the full performance of the Index and movements in the level of the index may affect whether or not depositors receive any return. So if the index goes up 50% you may have a gain of 30% for example.

• Depositors’ yield may be less than that of a standard debt security of comparable maturity.  In other words, if the stock market declines for the entire period the investor will be left only with 100% principal not with a 3% annual growth.  On the other hand, a stock investor will be possibly left with less than 100% of principal.

• A client would be required to declare phantom income on an annual basis if the investment is placed in a non-qualified account which raises their cost basis so that at maturity, they are only responsible for the difference.

• Neither NEXT Financial Group, Inc. nor its representatives offer tax advice.