Are index-linked CDs a sucker bet?

Investors seeking the safety of government-insured certificates of deposit and a chance to profit from market rallies may end up earning nothing and owing taxes for their efforts. Wells Fargo & Co., the fourth-largest U.S. bank by assets and deposits, and Sovereign Bank, are among those providing certificates of deposit tied to equity indexes, commodities or currencies. Wells Fargo sold about $5 billion of these market-linked CDs last year and Sovereign's CD, which links to the performance of the Standard & Poor's 500 Index, has attracted $1 billion since October. “Market-linked CDs are a great selling tool for nervous nellies, but they don't realize what's involved,” said Tom Balcom, founder of Ibis Wealth Management in Boca Raton, Florida. The products blend the potential for higher returns than current time-deposit interest rates with safety, because the principal is insured by the Federal Deposit Insurance Corp. If the index doesn't gain, the investor may not earn anything. Union Bank, a subsidiary of San Francisco-based UnionBanCal Corp. is offering a 5-year CD this month tied to the Dow Jones-UBS Commodity Index with gains capped at about 30 percent to 40 percent over any potential rise in the index. In one scenario, to earn the equivalent of 5.38 percent annual interest, the index would have to close at least 30 percent above its initial level at maturity, according to the bank's 42-page prospectus. The minimum return is 0.98 percent a year over the term of the CD. High Volatility Structured CDs tend to sell better in times of high volatility, said Tom Orecchio, principal at Modera Wealth Management, based in Westwood, New Jersey. Investors fled U.S. equities for the sixth straight week, pulling $3.7 billion from domestic stock funds in the period ended June 9, according to data compiled by the Investment Company Institute, a trade group in Washington. “There are other ways to get similar returns without all the complications,” Orecchio said. Market-or-index-linked CDs are an estimated 15 percent to 20 percent of total volume in structured investments, about triple the percentage before the financial crisis of 2008, according to Richard Couzens, New York-based head of product origination for investor solutions at Barclays Capital, a unit of Barclays Plc. Barclays develops CDs linked to equities, commodities, currencies, interest rates and inflation, and provides them to broker dealers, registered investment advisers and private banks, Couzens said, who declined to provide sales figures. They typically are aimed at risk-averse investors, he said. Structured Notes Many firms that offer these products also sell structured notes, which are bank bonds with yields linked to stocks that don't carry insurance. After Lehman Brothers Holdings Inc. went bankrupt in September 2008, leaving its structured notes worth pennies on the dollar, banks began offering more of the CDs, said Matt Ginsburg, San Francisco-based head of the customized investment solutions group at Wells Fargo. “Because investors wanted FDIC insurance, you saw market participants step up their issuance of CDs,” Ginsburg said. The limit on deposit insurance was raised in 2008 to $250,000 per account from $100,000, which also helped CD sales, Ginsburg said. The limit is scheduled to return to $100,000 after 2013, leaving larger CDs uninsured, unless Congress acts. “Investors are desperate for yield, the Fed has created a zero interest-rate environment and it's leading people to stretch,” said Frank Partnoy, professor at the University of San Diego School of Law and a former derivatives trader. “The banks are responding to that demand.” Higher Fees The products are attractive to sell because they generate higher fees, Partnoy said. Commissions generally range from 1 percent to 3 percent, said Ginsburg. Sovereign, a subsidiary of Spain's largest bank Banco Santander SA, offers customers a package: a six-month, traditional CD with 2 percent interest and a three-year CD that pays 2.9 percent annually if the value of the S&P 500 Index is higher than the purchase date at the end of every 12 months, said Nuno Matos, head of retail business for the company. If the index doesn't rise, the investor doesn't earn any interest, he said. “Rates are very low on traditional CDs right now. As a result, clients are sitting on cash,” said Mark Valentino, vice president and senior structured product specialist at Union Bank. “By linking these CDs to various asset classes we're able to offer clients some growth potential and portfolio diversification, along with some of the benefits that traditional CDs have.” Rate Calculations Wells Fargo's brokerage unit sells clients different types of certificates tied to equity indexes, currencies or commodities each month, said Tim Froehlich, director of alternative investments at Wells Fargo Advisors, based in St. Louis. In April the firm offered a 5 and a half-year CD linked to the S&P 500 Index. Froehlich declined to comment on sales. Savers should check whether the certificates are insured by the FDIC or the financial institution offering them and how the rate of return is calculated, said Colin Healy, managing director in the Mill Valley, California, office of HighTower Advisors. Investors may miss out on market gains depending on when the CD matures and what dates banks use to measure performance, said Healy, whose average client has $5 million in investable assets. For example, the market may be up and then dive a month prior to maturity leaving an individual with little or no return other than the principal, Healy said. Tax Consequences There also are tax consequences, Orecchio, the wealth adviser, said. The investor has to pay taxes every year on the implied interest income, which the bank estimates based on comparable CD yields, even though the market-linked CD doesn't pay out until maturity, Orecchio said. An investor is taxed at ordinary income rates, instead of lower capital-gains rates on stocks, which for top earners may mean a levy as high as 35 percent compared with a 15 percent long-term capital-gains rate. Disclosure statements provided to investors describe the tax consequences of the products, said Wells Fargo's Ginsburg. Investors may be able to claim an ordinary income loss if they pay taxes on more than they earn, according to the Internal Revenue Service. Investors can build their own market CD by purchasing a type of U.S. Treasury security known as a zero-coupon bond because it's sold at a discount to the maturity value and doesn't make periodic interest payments, and then investing the difference between the purchase price and the redemption amount, said Healy. For example, a saver might buy a zero-coupon bond priced at about $910 on June 4 with a face value of $1,000 that matures in February 2015, and invest the remaining $90 in the market. “The biggest thing you have to worry about is tying your money up for five years,” Healy said. “By doing it yourself you can unwind if interest rates increase or the market is doing well.”