Market-Indexed CDs May Be Too Good to Be True

With some investors fleeing the stock market in the wake of its recent wild swings, a few banks think they have created an attractive alternative: so-called stock market-indexed CDs.

The idea is that you sign up for a normal CD, say of one-year or three-year term. Instead of earning interest, however, you get a percentage of any stock market gain during the CD’s term. If the market falls, you get no return--but your principal is 100% guaranteed (and federally insured).

If this sounds too good to be true, it may be. Despite their market link, these CDs aren’t necessarily pure proxies for stock ownership. Your return, even in a strong bull market, may not be even close to what you’d earn owning real stocks.

But savers who find current CD yields still too abysmally low, and who think the stock market has more life left in it, might consider stock CDs for a small portion of their short-term savings. And you might want to act fast, because as stock market volatility increases, the banks may be forced to reduce the payout on future stock CDs.

In Los Angeles, Glendale Federal Bank and Great Western Bank have been heavily promoting stock CDs, with mixed results. Nationwide, these hybrid CDs are being offered by NationsBank, Mellon Bank and Citibank, among others, according to Bank Rate Monitor newsletter in North Palm Beach, Fla.

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Here’s how stock CDs work: You give the bank, say, $10,000 for three years. The bank agrees that at the end of each year, it will pay you a share of any gain in the stock market, most likely as measured by the price change of the Standard & Poor’s index of 500 blue chip stocks.

Your money isn’t invested in stocks, however. It stays with the bank, probably to make real estate loans. With the interest that the bank would otherwise have paid you, it plays the stock market via option contracts--or it pays a Wall Street brokerage to do the same.

With a “call” option on the S&P; 500 index, the bank can essentially own the right to buy a large basket of stocks in the future, at a set price, for relatively little money down right now. If the stock market goes up, so does the value of the call. If the market goes down, the call expires worthless.

Hence, the bank can make a pact to pay you a rising return in a rising market, or no return at all if the market drops. Your principal, meanwhile, isn’t at risk.

So let’s say the S&P; 500 index, which closed Thursday at about 451, rises 10% over the next year, to 496. You’d earn 10% on a stock CD, right?

Not necessarily. The formula most banks use to calculate your return is based on the average monthly performance of the S&P; for each 12-month period. For the sake of illustration, say the S&P; goes nowhere for 11 months, then suddenly jumps to 496 in the last month. Multiply 451 times 11, add 496, and you get 5,457. Divide by 12. The average S&P; index for the period would be 455.

Your stock CD return for the year thus would be about 0.9%--less than one-tenth the actual market gain, and well below the 2.5% to 3.5% you might have earned in interest on a normal CD.

If the S&P; were to rise steadily over the 12 month period--say, five points a month--your CD return in this example would be about 6.1%, versus the market’s actual 12.2% return. But this bull market is now 42 months old, so the odds of a steady upward trend from here are low indeed.

More likely, many Wall Streeters say, the market’s recent volatility is a taste of what’s to come. And if that’s true, these stock CDs may soon become less appealing even for savers who think the risk-reward equation is fair.

Why? As market volatility increases, so does the cost of option contracts on the S&P; 500 and other stock indexes. That makes it more expensive for the banks to play the market. If their costs go up, they will most likely reduce the guaranteed “participation rate,” meaning the percentage of any market rise that they’ll share with you.

And if volatility increases too significantly, chances are these CDs will fade away, as they did for a long time after the 1987 stock market crash (yes, this is their second incarnation). A volatile market costs the banks too much to hedge, and probably would cause many investors to shun market-related investments anyway.

Stock CDs: Some Pointers

A few considerations to keep in mind, if you’re shopping for a stock market-indexed CD:

* Taxes. Any return on your CD will be taxed as ordinary income. In contrast, long-term capital gains on actual stocks or stock funds are taxed at a lower rate.

* Early withdrawal penalties. They’re steep--up to 20% of your principal in the first year. Ask the bank to compare the penalty on stock CDs with the penalty on a normal CD, so you can see the difference.

* Risk. Banks play the options market to produce the return, if any, on your stock CD, which means you’re a party to a “derivatives” transaction--those hybrid securities that have been so much in the news lately for their alleged risky nature. However, it’s the bank’s money at risk, not yours: Your principal is 100% federally insured. But if the bank should fail, it isn’t clear that federal insurance would cover any stock market-linked gain you’re entitled to.