Equity-linked CDs flirt with Jason

By DAVID MOON, Moon Capital Management
September 28, 2003

I never saw any of the forty-seven different Friday 13th movies, but my understanding is that an unfriendly creature named Jason keeps returning to attack unsuspecting teenagers.

If you've considered buying the newest thing - a bank CD with returns 'linked' to the stock market - you're flirting with Jason. No, these FDIC-insured CDs won't chop you into little pieces. But like Jason, they do keep coming back to wreak havoc on their victims.

Each generation of equity-linked CD looks a little different, but they won't go away and stay away. And the result is the same: investors think they are buying something that guarantees the possibility of stock market returns with no downside risk. Au contraire.

The pitch has become more sophisticated. The new products promise that your minimum return will equal 100 percent of the S&P 500 return, with a couple of caveats. There are always a couple of caveats.

The big exception is that your quarterly return is limited to, at most, five percent, regardless of the return of the S&P 500. But there is no similar limit when the S&P 500 declines ' you get all of the losses.

If the S&P 500 increases twelve percent one quarter, followed by a seven percent loss the following quarter, an investor might expect the value of his CD to increase by about five percent. (The 12 percent increase, less the 7 percent decline.) But because the first quarter's return is capped at five percent, the seven percent loss in the second quarter more than offsets the limited gain in the previous quarter. You get all of the downside, with only limited upside.

This isn't a good bet. The S&P 500 return was positive in only four of the last nine quarters. In each of those cases, the positive return exceeded five percent. The return of this type of CD would have been capped. But the downside quarters were significant. In three of the quarters, the loss exceeded more than thirteen percent. Does that sound like a great deal? You get credit for all of the downside and only some of the upside? In the last five years, there would have only been two quarters in which the return of such a CD would not have been limited by the upside cap.

On the positive side, these CDs are FDIC insured. And they do guarantee a minimum of a three percent TOTAL (not annual) return over a four or five year period. No one is going to lose their money. But they aren't likely to get what they expect, either.

The investment climate in which this type of product is likely to do best in one where the returns of the S&P 500 aren't very volatile (less than five percent a quarter changes) and are generally positive. But if you expect that kind of stock market, you would buy stocks, not CDs. And if you wanted to hedge your stock investment, you would put some of your money in something paying a reasonable guaranteed interest rate, not a total of three percent.

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

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