The Pros And Cons Of Structured CDs
The stock market has been on quite a ride this year, with the DJIA up over 22% to date. On the other hand, we all remember the dark days of the banking crisis, and are perhaps wary of another period of turbulence on the exchanges. This is made all the more acute by the recent meteoric rise – are valuations taking us to the point where we are entering another bubble?
If you share these concerns, you are probably looking for an investment vehicle that can participate in the market’s growth while limiting risk. If so, one of the options you have is a structured CD. This has the potential to give you much higher rates of return than a traditional CD. For instance, if you look at this overview of best CD rates, you will see that the most you are likely to get at the moment with a traditional CD is about 1.5% a year. A structured CD can yield significantly more than this because it is linked to a stock market index – most commonly the S&P 500.
The way that a structured CD works is as follows. You invest a fixed amount, and you are guaranteed to get that fixed amount back once the CD reaches maturity. In fact, this principal amount is insured by the FDIC up to $250,000 – just like any deposit account. If the market goes down, you will still get back your full upfront investment. However, if the market goes up, you will get a percentage of that market increase as interest. This percentage is known as the participation rate – for instance, if the market goes up by 10% in a year and the participation rate is 60%, then you will get a 6% return.
The big advantage of a structured CD is that it gives you exposure to market growth without any risk that you will lose your initial outlay, since the CD is FDIC insured. Because of this, your returns have the potential to be high, particularly when compared to fixed income assets such as treasury bonds. It also helps to diversify your portfolio, since it is linked to an overall market index, as opposed to a single security.
On the other hand, while this may seem attractive – and it is for many investors – there are still a number of issues that you need to be aware of before putting your money into structured CDs. One of these is the returns that you will get in a flat market or one with extreme growth. If the market does not grow at all, you could end up just getting your original investment back and nothing else. This is made worse by the fact that there are usually very heavy penalties for early withdrawal, so you could find yourself locked into a poorly performing investment for a number of years. On the other hand, returns are usually capped, which means that if the market rises quickly, your returns are limited – no matter what the participation rate. Earnings from structured CDs are also taxed at a higher rate than traditional CDs because they are a market investment, and this tax must be paid annually – even if the CD does not pay out until it matures.