Investing: Should You Test-Drive a Hybrid CD?
When it comes to certificates of deposit and other essentially risk-free products offered by FDIC-insured banks, some depositors might not feel comfortable thinking of themselves as investors. After all, the appeal of keeping some money in cash is knowing your principal is protected. But as the current low-interest rate environment drags on, more and more people are getting antsy about earning next to nothing on the money they choose to save rather than invest. Hence, the growing allure of index-linked CDs, now available from a handful of banks across the U.S. One example: Sovereign Bank, with 750 branch offices across eight East Coast states from New Hampshire to Maryland. Acquired by Banco Santander (STD) in January, Boston-based Sovereign is offering a Save-and-Invest CD for minimum deposits of $5,000. Half of the deposit is invested in a six-month CD paying a fixed rate of 2.25%, while the other half goes into a 36-month CD whose interest rate is tied to the performance of the Standard & Poor's 500-stock index. Although the fixed rate on the six-month portion actually comes to 1.13%, half of the annual percentage yield, it's still generous compared with the national average of 0.56% for standard six-month CDs as of Nov. 12. On the portion of their deposit that is invested for three years in the S&P 500, customers are guaranteed a rate of 3.0% as long as the index is up as little as 0.01% at the end of the first year. Depositors may not like seeing their interest capped at 3% if the market advances 20%, however. The interest earned after each year is added to the principal, allowing customers to walk away with more than they initially deposited even if the stock market is down when the CD matures. Sovereign introduced the product to help customers struggling with two challenges—low yields on their savings and uncertainty about the stock market, with 2008 losses still fresh in memory, says Nuno Matos, head of Sovereign's retail business group, which creates and markets new products. "The six-month CD is for the savers, and the medium-term investment is where people can make money in a safe way if the market goes up." The early withdrawal penalty for customers who pull out within the first year is 9% of their principal, 6% for those who exit during the second year, and 3% for those opt out during the third year. Sovereign launched the product on Oct. 19 and its offer ends on Nov. 27. Matos wouldn't disclose the bank's targets for participation but says customer response has been positive. One branch, however, had reached only one-quarter of its deposit goal for November, according to an insider. Depositors' resistance to the CD stems primarily from skepticism toward ongoing gains by the S&P 500 index, said the source, who wished not to be identified. Index-Linked CDs' Popularity ExplodesInvestors who want the downside protection but also seek higher growth potential can get it through index-linked CDs offered by banks such as SunTrust Banks (STI) and Union Bank, but they need to have brokerage accounts to buy into them. SunTrust has attracted more than $1.0 billion into index-linked CDs since it started to offer them five years ago, but their popularity has exploded with inflows of $400 million in just the past year, says John Rhett, chairman of SunTrust Investment Services, the bank's brokerage division. "People who are risk-averse—they still need [their assets] to grow in order to retire," says Rhett. "This gives you downside protection and gives you the opportunity to grow. That's a very attractive combination in today's world." The most prevalent CDs are linked to the S&P 500 index, with products tied to the Dow Jones industrial average coming in second. Each issue has a different cap on appreciation based on market conditions for that index. The more volatile the index, the higher the cap can be, because volatility works to your advantage in the futures market, where the investments are hedged, says Rhett. Returns on CDs linked to the S&P 500 are generally capped at 20% to 30% of appreciation in the index. SunTrust's CDs have the added feature of providing annual income to those who desire a steady payout, in exchange for a lower cap on returns at maturity. For CDs tied to the DJIA, for instance, customers could get back 2% of their principal in cash each year but would get a 20% lower cap on their return at maturity than they would without getting the annual income, says Rhett. For more sophisticated investors, SunTrust also offers CDs linked to international equity indexes such as Japan's Nikkei 225 and the FTSE 100 in the U.K., which have potential for higher returns and hence higher caps on returns. Rhett says he stays away from indexes in emerging economies like Brazil, however. UnionBanc Appreciation Caps of 50% to 65%San Francisco-based Union Bank, a member of Mitsubishi UFJ Financial Group (MTU), offers an assortment of market-linked CDs through its broker, UnionBanc Investment Services. Although its broker has offices only in California, Oregon, and Washington State, its clients come from throughout the U.S. UnionBanc does about two index-linked CD offerings each month. The minimum required deposit is $5,000 and the term is generally five years. At minimum, an investor recoups his principal plus 5% in interest accrued at maturity (which translates to an annual percentage yield of 0.98%), even if the index has negative results for the five-year period. On the upside, the CD pays the appreciation on the index between start and end dates, up to a maximum of 50% to 65%, depending on market conditions at pricing, according to Beverly Henretty, manager of foreign exchange and derivatives sales at Union Bank. "To generate the return, we're buying an option on the index in most cases," she says. A five-year CD linked to the Dow Jones-UBS Commodity Index and offered in October priced at an appreciation cap of 58.75% and attracted $3.5 million in deposits. The current offering ends Nov. 20 and the cap on returns won't be set until it's priced. UnionBanc also offers three- and four-year CDs. The interest on shorter-dated CDs is calculated each quarter, with investors getting the greater of either the minimum return of 3% or 4% or the sum of each quarter's returns at maturity, says Henretty. Quarterly returns on three-year CDs are capped at 4.9%. Depositors must hold the CD for at least one year. After that, they can redeem it at market value only on the 15th day of the third month of each calendar quarter. "Investors who get out early can lose principal, but [the CD] can also be worth more than par value," says Henretty, referring to the principal deposit. Redemption requests must be received by the bank via the Depository Trust Co. three business days before the actual redemption date. Indexed vs. Non-Indexed: Rates DivergingEven if depositors are skittish about the direction of the stock and commodities markets, it's hard not to be enticed by indexed CDs given the widening divergence between their interest rates and those for non-indexed CDs. Since June, rates for indexed CDs have climbed an average of 8.1%, while non-indexed rates have declined more than 14%, according to Dan Geller, executive vice-president of Market Rates Insight, which provides competitive-pricing information and analysis to the banking industry. "This is the type of deposit that low-risk-minded people can take and sleep well at night because, unlike investing in the stock market or a mutual fund, it will not impact your principal adversely if the market goes down," he says. "Granted, the return potential is not as great as if you invested [directly] in the stock market." That said, given how relatively low interest rates are these days, every little bit counts, he adds. For people who can't stomach the idea of exposing their savings to any market risk, there are non-indexed CDs issued for nonstandard terms such as 9 or 13 months that often pay a premium over the average rate, according to Jaime Peters, an analyst at Morningstar (MORN) who covers consumer banks. A bank will typically offer this kind of product to better match the maturities of its assets and its liabilities and reduce its balance sheet's sensitivity to interest rate moves, she says. And for the plainest of plain-vanilla CDs, the best deals on yields are still at online banks, which can afford to offer higher rates because of lower overhead expenses. These banks tend to dominate the top five rates listed in Bankrate.com's (RATE) weekly report. Until the economy gets on a more solid footing and the thought of a sustainable bull market becomes more credible, indexed CDs may be the best place for risk-averse investors to park their money and still get some upside without any loss of sleep. But be careful. If the recovery unfolds more quickly than anticipated, you'll want to have some cash free to invest in assets offering higher returns.