Adjustable-rate certificates of deposit, market-linked CDs, structured CDs, and equity-linked CDs all refer to a specific type of financial instrument that slightly resemble conventional CDs. However, these instruments are different from conventional CDs in that they do not guarantee a certain interest rate over the life of the investment. Instead, the interest rate of a structured CD is determined by a complex formula, the variable of which are often linked to an underlying benchmark or index.
Adjustable-rate certificates of deposit, market-linked CDs, structured CDs, and equity-linked CDs pay interest rate within a range, bottoming out at zero; the better the underlying index or benchmark performs, the higher the interest rate. Some equity-linked CDs are tied to the S&P 500, and tend to pay higher rates during times that the stock market is rising. On the other hand, adjustable-rate CDs that are tied to fixed income or derivative benchmarks or indices tend to do poorly in this environment. However, the actual rate paid on an equity-linked CD over a long-term basis is not guaranteed, because these products are callable at the discretion of the issuing institution. As a result, very little about structured certificates of deposit are guaranteed.
Variable-rate CDs have a built-in “callable” feature. This means that the issuing institution can call, or redeem, the product when certain conditions are met. Of course, a bank has no interest in calling a product that is paying zero percent interest. However, if an equity-linked CD is paying interest at or near the maximum of its range, the issuing bank may call the product, limiting the amount of time the investor receives the higher interest rate. As a result, purchasers of adjustable-rate certificates cannot get out of the product if it performs poorly, yet cannot count on realizing the potential gain the product has to offer.
Drawbacks to Structured CDs
There are several drawbacks to market-based certificates of deposit, including:
- Penalties for early withdrawals – If you need to access the money in a variable rate CD before the instrument’s maturity, there are monetary penalties. Thus, investors tend to avoid early withdrawals except in cases of an emergency.
- Call risk – If the issuing institution believes it is in its favor to redeem the CD before maturity, the institution can call the equity-linked CD. A CD’s call price heavily impacts the price of the CD, because in favorable market conditions a CD could likely be called. This also prevents an investor from being able to rely on receiving a higher interest rate even when the market moves in a favorable direction.
- Interest rate variability – During unfavorable market conditions, a variable rate CD will often pay less interest than a conventional CD. Some market-linked CDs carry the potential to yield no interest at all. The variability of interest rates is a considerable drawback for many investors who prefer certainty over speculation.
The Current Interest Rate Climate Negatively Affects Many Variable-Rate CDs
One of the most basic tenets of finance is the time value of money, which essentially means that access to money is not free. If someone wants to borrow money, they must pay the bank interest while the loan is outstanding. A common-sense corollary to this principle is that the longer someone wants to borrow money, the higher the interest rate they must pay. And in times of rising interest rates, this assumption holds true. However, when rates are decreasing, interest rates for long-term debt may be lower than those for short-term debt. This phenomenon is known as the inversion of the yield curve.
The yield curve measures the difference between long-term and short-term debt. When there is general consensus that interest rates in the future will be lower than they are today, the yield curve is said to be inverted. An inverted yield curve is generally agreed to be a precursor to a recession.
Not only is an inverted yield curve a cautionary sign for the economy, but it has an impact on market-linked CDs that are tied to fixed income and derivative benchmarks. The rates paid by a variable-rate CD fluctuate pursuant to a complex formula contained in the product’s prospectus. Simply stated, when the underlying benchmark performs poorly, structured-CDs that are tied to that benchmark will also perform poorly. Because fixed income and derivative benchmarks are negatively impacted during times of an inverted yield curve, market-linked CDs tied to these benchmarks suffer as well. Often, these products will pay zero interest when the yield curve is inverted, leaving holders of adjustable-rate CDs with a product they cannot get out of and that does not pay any interest.
In addition, low long-term interest rates mean that investors who locked their money away in an equity-linked CD paying little to no interest are foregoing the current opportunity to earn more interest on short-term certificates or investments. While selling investment products that result in an investor missing out on better opportunities is not problematic per se, investment professionals must advise investors that such a scenario is possible.
Proper Investment Advice Means Full Disclosure of a Product’s Features and Performance in Good Times and Bad
Financial advisors are duty-bound to recommend suitable investments to their clients. In fact, the cornerstone of responsible investment advice is ensuring that a product is suitable for an individual investor. Brokerage firms and financial advisors must learn all material facts about an investor before making any recommendations. They must also match all investments with a customer’s stated investment profile. Failure to recommend suitable investments may result in a claim to recover attenuating investment losses.
In the case of variable-rate CDs, there are two concerning features that financial advisors and brokerage houses may not have disclosed to investors:
The variability of the interest rate: Investors who purchased market-linked CDs that were tied to a poorly performing benchmark or index are likely receiving little to no interest on their deposits. Interest rate variability is a material fact about adjustable rate CDs that must be disclosed to a client before an investment professional can recommend these products.
The callability of the product: Investors who initially benefited from the underlying index or benchmark moving in the right direction may find themselves feeling short-changed by an equity-linked CD if the issuing institution called the CD. The callability of a financial product is another material fact that must be disclosed by an investment professional before selling a product to a client.
If an investment advisor did not disclose either of these material characteristics of market-linked CDs, investors who experienced a loss of income or principal may be able to recover losses related to the purchase of the product.
Did You Suffer Financial Losses or Miss Out on Other Opportunities After Investing in a Variable-Rate CD Product?
If you purchased Market Linked certificates of deposit, Structured CDs, Adjustable Rate CDs, or Equity Linked CDs, and have either experienced a loss of income principal, you may be entitled to recover those losses from the issuing institution.
The Wolper Law Firm represents investors nationwide in securities litigation and arbitration on a contingency fee basis. Matt Wolper, the Managing Principal of the Wolper Law Firm, is an experienced trial lawyer who has handled hundreds of securities cases throughout his career involving a wide range of products, strategies and securities. Prior to representing investors, Attorney Wolper was a partner at a national law firm, where he represented some of the largest banks and brokerage firms in securities matters. Through this experience, Attorney Wolper developed the command of securities law that he puts behind each of his clients’ cases. Wolper Law Firm can be reached at 800.931.8452 or by email at email@example.com.