Posts Tagged ‘cap rate’

It’s natural for investors who are still skittish after a decade-long roller coaster ride with the stock market and plummeting real estate values to be risk averse and seek out investment alternatives for protecting their nest eggs for retirement, college funding or simply their emergency cash.

And where there is demand, there will be supply.  So naturally, financial firms will design products geared toward satisfying this demand.

One such product that’s getting more attention recently are Market Linked Certificates of Deposit (CDs).

These are in essence a savings product designed to provide a minimum guaranteed interest rate plus the opportunity to increase the return by linking to the return of a specific market index or in some cases an index for inflation.

Such products are part of the larger class of “structured products” produced by investment banks that can come in many flavors and various strategies:  reverse-convertibles, principal-protected notes, Exchange Traded Notes.  They essentially are debt bundled with a derivative and marketed as a way to bet on stocks and interest rates as a way to manage certain risks. All offer in one package strategies using some sort of derivative and may offer a combination of principal protection, risk reduction and/or enhanced returns.

Recent surveys of more than 17 brokerage firms and more than 38 million investors show that most of these products are used by those with under $500,000 in investable assets.  For those with assets between $250,000 and $500,000, about 1.5% of their assets are placed in such products which is slightly higher than the 1.33% of assets for those with under $250,000 to invest.  (Investment News, 11/15/2010, page 52).

More than $70 billion of such products are held by investors with more than $42 billion bought in 2010 according to Bloomberg data.  And given continued uncertainty about the markets, the demand looks like it will not be abating any time soon especially as financial marketing organizations use investor fears as a selling point. Brokers and banks often receive higher fees and commissions for selling such products.

Keith Styrcula of the Structured Products Association said in a recent interview “these kinds of investments have become so attractive because people can no longer trust stock market indexes to go up.” He added that “there’s a lot of fear in the market right now, and a lot of investors don’t just want one-way exposure anymore.”  (Investment News, 11/15/2010, page 51).

But even though these products are marketed as a way to reduce risk they are not risk free.  There is no free lunch and this is no exception. Such products are subject to liquidity risk, market risk, credit risk and opportunity costs.

Market-Linked CDs are a form of principal-protected note offered by an investment bank.  These are not your Grandmother’s bank CDs.  First, such notes are offered as debt of the sponsoring institution so there is always the potential of credit risk.  Think of Lehman Brothers which was a large producer of such notes.  If the issuing firm fails, as Lehman did, the investment is at risk. While there is FDIC-protection on the principal, that may be small comfort when dealing with the time frame to get access to your money through a FDIC claim process.

They may involve a complex strategy which may be buried in the details of the offering’s prospectus.  For market-linked CDs, for instance, the issuer offers the downside protection by managing a portfolio of Treasury bonds (like zero coupon bonds to meet the projected maturity date of the CD).  The upside potential that is offered comes from investing in the bond yield through various strategies.

In such a low interest rate environment, these notes work only if provided sufficient time for the issuer to implement its strategies.  This is one reason that such CDs typically have long lock up periods that can be five years or more.

An issuer may guarantee a minimum interest amount but this is typically not FDIC-insured.  And this is really an obligation of the issuer so that’s where the credit risk comes into play. And you should note that the minimum guarantee usually only applies when the investment is held to maturity.  An investor will lose this guarantee by redeeming before the contract maturity date. And because of the nature of these products, there really is no secondary market around to allow someone else to buy you out early.

The upside potential is calculated based on the performance of the index chosen.  The CD investor does not own the index or the stocks in the index.  The issuer uses its money to invest and potentially reap the dividends issued as well as the appreciation.

What the issuer offers to the CD investor is a certain percentage of the upside gain of the index (called a participation rate) but limited by a ceiling (called a cap).  This calculation of the gain can be convoluted for an investor to understand. While it’s pretty simple to understand a typical CD (put $1000 in at an annual interest rate of 3% means you have $1,030 at end of the period), the same is not true for market linked CDs.

Your gain may be based on an average (so now the question is how are they calculating that average: monthly,  semi-annually, annually, term of the CD) or a Point-to-Point calculation. (Example: If the market index is 1000 when the account opened, went up to 2000 after one year but drops to 1050 by the maturity date, then the point-to-point is from 1000 to 1050 or 5% in this case).

In many ways these are similar to other structured products like market linked annuities (sometimes referred to as index annuities or equity-indexed annuities).

I addressed many of the same issues about calculating returns and possible risks in a post on the subject a while back.

Bottom Line:

Whether or not such products make sense for your personal portfolio really requires a good, long chat with a qualified financial professional. Like any other investment, the potential risks and opportunity costs need to be weighed against your personal goals, time frame, liquidity needs and the potential offered by other alternative options.

So if you are considering such products, just be aware of all the risks and look beyond the marketing brochure at the local bank.


SEC Investor Education on Market-Linked CDs

MoneyLinkPro Blog Post on Market Index Annuities

Wikipedia Definition


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