Investing: Should You Test-Drive a Hybrid CD?

Equity-linked certificates of deposit are designed to boost yields by tying a portion of the deposits to a stock index. Here's what investors need to know

By David Bogoslaw

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 Explodes

Investors 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.

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