Ask the Adviser: What’s a Market Linked CD and Are There Risks?

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.

Resources:

SEC Investor Education on Market-Linked CDs

MoneyLinkPro Blog Post on Market Index Annuities

Wikipedia Definition

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How to Ride a Bond Bubble and Survive a Secular Bear Market

After the Dow Industrials reached their peak on October 9, 2007, there was a long, painful decline to the trough reached on March 9, 2009.  During that time the DJIA lost 54% but was followed by a rally of 70%. Even with this spectacular run up through 2009, the index never reached it peak. While closer now after a good 2010 it, the peak is still a long climb up the mountain.  In fact, to break even from a 50+% loss requires a disproportionate increase (more than 100%) just to “get back to where you once belonged” as the classic rock song lyrics said.

Investors Win By Not Losing

As this roller coaster shows, its easier to keep what you have than try to rebuild it.  Unfortunately, after such volatility, investors tend to flee to places that are perceived to be safe.  For most that has created a flight to bonds. While investors think of risk as “loss of capital” the traditional views of risk continue to be turned on their head. Sure, you could stash your money away in a money market or under the mattress but what kind of return will that produce?  Will you have enough to eat more than dog food in retirement?

A recent documentary on the disaster at Pompeii and Herculaneum shows how many townspeople fled to the concrete tunnels near the wharves.  Considered a safe place, it ended up as a tomb to more than 300 skeletal remains. These hopeful survivors were trapped by the lava flows which sealed up the tunnels where they had fled.

In many ways, investors fleeing the danger of the markets by shifting to government bonds could be dooming themselves to a similar fate as the Pompeians.

The returns from “safe” Treasuries are pathetic.  Huge investor appetite has driven up to demand and helped lower the yields offered.  A backlash could hurt investors when interest rates rise as they inevitably have to.

If the goal is to preserve capital and avoid dangers, it shouldn’t matter to an investor what asset class is used.  (It’s Halloween.  Watch any scary movie and when the hapless victim is trapped he/she could care less whether the guy in the hockey mask is stopped by a dump truck or an arrow).

In much the same way, we should be looking at other ways to conserve capital.

Carrying Junk Around

Say “junk bonds” to someone and they may be thinking about Michael Milken in the 1980s or businesses on the brink of bankruptcy.  While these bonds are issued by companies with lower credit ratings, they offer a very good alternative to “safe” Government bonds. The point of diversification is to not put all your eggs in one basket.  Today most investors are torn between a savings account paying practically no interest or reaching for yield using alternatives.

The bond market prices the risks of bonds every day.  Currently, the bond market is pricing in a possibility of 6% default risk on junk bonds as a group.  That’s down from its historic number. Some individual bonds of companies may certainly be higher but as a group that’s not a bad number.  Some analysts at JP Morgan Chase have even estimated that the default risk for 2011 is as low as 1.4%.

Why so low? The projected default risk is low in part because companies are showing their highest level of profits in years.  They have shed workers, squeezed productivity gains from those remaining and taken over market share as weaker competitors have failed. The prospects for these companies look even better considering that as a recession ends company cash flows improve.  This means more cash available to service debt. And as these companies improve so too will their credit ratings leading to lower interest rates that they can get when they refinance their debts just like any homeowner would who has an improved credit score.

Avoiding the Danger of a Secular Bear

In a secular bear market, there are rally periods while the markets as a whole may languish or sometimes drop.  During the secular bear from 1/1/1965 to 12/31/1985, a Buy and Hold bond investor would have been whipsawed but ending up gaining about 1 basis point (or 0.01%)  per year for 20 years.  Not a lot of payback for the sometimes stomach-churning ride over that time.

A More Tactical Approach to Risk Management

Not all bonds are the same.  There are government bonds, municipal bonds, US investment grade corporate bonds, US hi-yield/junk bonds, convertible bonds, bonds from overseas and bonds from emerging markets.  Just like every homeowner applying for a mortgage is different and has to go through different underwriting,  the characteristics of all these bonds are different as well.

For instance, hi-yield bonds are more likely subject to credit risk.  Since the rates on these types of bonds are higher than that found on a Government bond or investment grade corporate bond, they are not so sensitive to changes in interest rates.  On the other hand, Government bonds are more sensitive to interest rate risk and the perceptions about expected inflation or the impact of monetary and fiscal policy on future interest rates.

Since these two bond categories are influenced by different factors, they tend to not be correlated meaning that they don’t move in lock-step: When one is zigging the other is probably zagging in the opposite direction.

A key way to reduce risk and potentially increase returns when dealing with bonds is to rotate among the different bond types.  Sometimes the market conditions favor one flavor of bonds over another.  At other times it’s better to reduce all bond types and shift to cash or money markets.

Simply buying and holding means that gains made in one period may be taken away by another. If you’re able to make gains and take them off the table from time to time, you’ll have less money at risk and greater opportunities at preserving capital for the long term.

In the chart below, you can see that buying each of these major bond indexes can produce widely different results.  For nearly the same risk level (as measured by the standard deviation), US High Yield long term bonds have a clearly higher overall return and higher return during periods of higher interest rates than the long-term US Treasury index.

Bottom Line

Investors seeking ways to add income to their portfolio and reduce risk of loss to their capital really need to consider alternatives to buying and holding.  Rotating among these different bond asset types may reduce the overall volatility to the portfolio and preserve capital for the long term.

If you don’t want to end up like the victims of Mount Vesuvius and be buried by a “safe” move, you should open your minds to understand all the risks and ways to manage them.

Figure 1 (Source: BTS Asset Management Presentation/Nataxis Global Assoc, 10/27/2010)

Bond Index	Annualized ReturnNov 1992 – Aug 2009	Standard Deviation (measure of risk)	Annual Return During Rising Rate Period
BarCap US High Yield Long	10.45%	10.94	6.75%
BarCap US Corp Baa Investment Grade	6.97%	6.31	1.75%
BarCap US Aggregate Bond	6.46%	3.82	1.31%
BarCap LT US Treasury	8.11%	9.28	-0.40%

Figure 2 (Source: BTS Asset Management Presentation, 10/27/2010)

Bond Sector	Credit Risk	Interest Rate Risk	Currency Risk
US High Yield	High	Low	None
International Developed Market	Low	Medium	High
Long-term US Government	None	High	None
Emerging Market	High	Low	High
US Municipal	Low	High	None
US Investment Grade Corporate	Low	High	None

Figure 3 (Source: BTS Asset Management Presentation, 10/27/2010)

CAPITAL PRESERVATION KEY to LONG-TERM SUCCESS
Loss	Gain Needed to Get Back to Break Even
(15%)	+ 18%
(20%)	+ 25%
(30%)	+ 43%

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