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Market-Linked Certificates
of Deposit
Faced with low yields on traditional Certificates of Deposits, investors have been seeking avenues to
invest in other asset classes in order to increase their returns. However, while riskier investments such
as equities, commodities and currencies may offer the potential for greater returns, they also expose
investors to the risk of loss to their principle investment. Enter the world of Market-Linked Certificates
of Deposit (MLCDs) which may provide investors with participation in the long-term growth potential
of these other asset classes while providing for downside protection through FDIC insurance.
How MLCDs work
Equity Indices and Other Reference Assets
There are various structures available
for MLCDs but there are two main
components that make up these
investments. The first component
is a Certificate of Deposit to which
FDIC coverage applies — in the event
that an institution fails, the deposit
insurance covers principle repayment
up to certain statutory limits*. With this
coverage as a backdrop, the MLCD is
100% principal protected when held to
maturity.
S&P 500
Commodities
NASDAQ 100
Foreign Currencies
DJIA
Interest Rates
Nikkei 225 (Japan)
Individual Equities
DJ EuroStoxx (Eurozone)
Exchange Traded Funds (ETFs)
The second component to the MLCD
structure offers clients exposure to a
wide range of investment options while
providing the potential for enhanced
returns. This is accomplished through
the added purchase of options on
individual equities, U.S. or International
indices, commodities, currencies and
interest rates. Structures may give
investors the opportunity to invest
in asset classes that may be difficult
or expensive to participate in on the
individual level.
Hang Seng China Enterprise (China)
Hypothetical
When an issuer creates an MLCD,
they first use a portion of the available
assets to structure a zero coupon bond
(or bond equivalent) that matches
the maturity and principal amount
of the MLCD under consideration.
Zero coupon bonds are issued at a
discount to their face value and do not
pay interest. This allows the issuer to
structure a CD that will return $1,000
at maturity for an upfront investment
by the issuer that is under $1,000. The
difference between the CD’s value
at maturity and the amount paid
represents the CD’s implied return and
this discount provides MLCD issuers
with excess capital to invest. In this
example, issuers will use this excess
capital to structure call options on a
broad based index, such as the S&P 500
index. A call option gives an investor
the right (but not the obligation) to
buy an investment in the index at a
specific price within a predetermined
period of time. The option will typically
have an expiration date that matches
the maturity date of the zero coupon
CD along with a “strike price”, or
initial price, that matches the current
value of the index. If the underlying
asset, the S&P 500 Index, increases
in value, the value of the call option
will also increase. By utilizing the zero
coupon structure, the MLCD investor
will, at the very least, receive their
initial investment at maturity; the
performance of the equity component
will determine any additional return.
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Typical return characteristics
include
•
Point to point — Compares starting
level to ending level
•
Averaging — Compares the starting
level to the ending level which is
based on the average of various,
predetermined observation points
•
Cliquet — Sum of the percentage
changes for set periods (usually
quarterly) and subject to a cap on
the upside
•
Participation — Final terms
multiplied by a factor greater than or
less than 1x
•
Annual income — Depositors
may receive a coupon annually
based upon the baskets’ average
performance vs. their initial levels,
subject to a cap and floor
•
Minimum return — issue will mature
at a set rate even if the final return
is lower.
$1600
Option creates
potential for
upside return
$1400
$1200
$1000
Purchase Call
Option
$800
Purchase
Zero coupon
$600
$400
$200
$0
Initial Investment
Liquidity
•MLCDs provide diversification with
exposure to a variety of markets that
may include: equities, commodities,
currencies and interest rates;
MLCDs are designed to be “Buy and
Hold” investments. Although MLCDs
may be sold prior to maturity, there is
no guarantee of a secondary market.
The volatility of the asset, time to
maturity, interest rates and credit
worthiness of the issuer can all affect the
value. Also, built-in-costs are likely to
adversely affect the value of the MLCD
which could result in substantial loss for
the investor if sold prior to maturity.
•Investments have a fixed maturity,
typically 3-10 years;
Investor profile
Appealing to a wide range of investors,
MLCDs may be attractive for a number
of reasons which can include:
•Receipt of the performance of the
underlying asset as measured by the
original terms;
•Capital preservation — 100%
principal protected through FDIC
insurance, when held to maturity;
•MLCDs have an estate put at
par (may be subject to certain
limitations);
•Potential for higher returns than
fixed-rate offerings;
•Minimum investment is typically
$1,000.
•Potential for equity-like returns with
preservation of principle;
Risk considerations
Performance
•Reduced taxes when purchased in tax
deferred accounts such as IRAs.
Investment @ Maturity
Benefits and features:
•Investor’s principal is guaranteed
if held to maturity (subject to FDIC
insurance limitations);
•Alternative to no-load indexed funds;
Zero coupn
bond matures
at $1000 per
CD
Since MLCDs are linked to the
performance of an underlying asset,
there are many economic and market
factors that may affect the overall return.
Additionally, the return may be limited
on the upside and if the underlying
asset declines at the end of the term, as
compared to the beginning of the term,
the gain may be zero. Investors may
receive a lower payment at maturity
than if the underlying asset was
purchased directly.
Credit
The MLCDs are FDIC insured, however,
any investment that exceeds the
applicable FDIC limits is subject to the
credit risk of the issuer. Insolvency of
the issuer may result in early repayment
of the principle of an MLCD.
Early redemption/reinvestment risk
MLCDs may be callable at the option
of the issuer but the issuer has no
obligation to do so. If an MLCD is
redeemed prior to maturity, the investor
may not be able to reinvest the proceeds
at favorable terms.
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Tax treatment
Conclusion
Investors who own an MLCD that is
treated as a contingent payment debt
instruments will be required to pay
taxes on imputed interest income at
ordinary income-tax rates each year
over the term of the issue. This will
be based on the issuer’s estimated
comparable yield, even though the
investor may not receive any interim
interest payments. In addition,
any gain or loss realized upon sale,
early redemption or maturation of a
contingent payment debt instrument
will generally be treated as ordinary
income. This tax treatment applies
unless the investor owns the MLCD in
a qualified tax-exempt or tax-deferred
account such as an IRA. For complete
tax advice, investors should consult with
their tax professionals.
Certificates of Deposit are a popular
investment vehicle largely due to their
high quality, relatively attractive yields
and means for investors to further
diversify their investments. Market
Linked Certificates of Deposit may
be added to a portfolio to address
a particular investment objective
whether one is a conservative investor,
a young family saving for college, a
baby boomer or retiree. MLCDs may
help take advantage of cross asset class
opportunities with the potential for
enhanced returns while minimizing risk
and market volatility.
For more information on these and
other investment opportunities, please
contact your RBC Wealth Management®
financial advisor.
*FDIC Insurance
The Dodd-Frank Wall Street Reform and Consumer Protection Act enacted on July 21, 2010, permanently raises the current standard maximum deposit insurance
amount to $250,000. The FDIC insurance coverage limit applies per depositor, per insured depository institution for each account ownership category. All CDs
offered through your RBC Wealth Management financial advisor are FDIC-insured.
In the event that a bank or thrift fails, depositors are fully insured up to $250,000. This insurance covers principal and interest up to $250,000. In addition,
Federal law provides up to $250,000 in deposit insurance coverage for self-directed retirement accounts, such as Individual Retirement Accounts (IRAs). It is
important to remember that this insurance ceiling applies to all deposits at a FDIC-insured institution. For example, if an individual purchases one or more CDs
from the same bank or S&L, for a combined total exceeding $250,000, the total insurance coverage is capped at $250,000. However, an individual can be fully
FDIC-insured on CD amounts greater than $250,000 in their RBC Wealth Management account if they purchase CDs from different banks or S&Ls in order to not
exceed the $250,000 limit at any one institution. Individual and joint accounts are insured separately, allowing a married couple (for example) to have up to
$500,000 worth of insured deposits at one institution.
For instance, if a husband and wife each have separate accounts containing $250,000 worth of CDs from the same bank or S&L, each individual account is
insured for $250,000. In addition, the same two individuals could also have a joint account with up to $500,000 worth of CDs, thereby having a combined total
of $1,000,000 in insured deposits from one institution. In order to remain fully insured, investors must avoid going over the insurance ceiling at any one institution.
RBC Wealth Management, a division of RBC Capital Markets, LLC, Member NYSE/FINRA/SIPC. © 2016 All rights reserved.
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