Page 1 of 3 Market-Linked Certificates of Deposit
Page 1 of 3
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
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.
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.
Equity Indices and Other Reference Assets
S&P 500
Commodities
NASDAQ 100
Foreign Currencies
DJIA
Interest Rates
Nikkei 225 (Japan)
Individual Equities
DJ EuroStoxx (Eurozone)
Exchange Traded Funds (ETFs)
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.
Investment and insurance products offered through RBC Wealth Management are not insured by the FDIC or any other federal government agency, are not deposits or other obligations of, or guaranteed by, a bank or any bank affiliate, and are subject to investment risks, including possible loss of the principal amount invested.
Page 2 of 3 Market-Linked Certificates of Deposit, continued
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
?M inimum return -- Issue will mature at a set rate even if the final return is lower
Investor profile
Appealing to a wide range of investors, MLCDs may be attractive for a number of reasons which can include:
?Capital preservation -- 100% principal protected through FDIC insurance, when held to maturity
?Potential for higher returns than fixed-rate offerings
?Potential for equity-like returns with preservation of principle
?Alternative to no-load indexed funds
?Reduced taxes when purchased in tax deferred accounts such as IRAs
$1600 $1400 $1200 $1000
$800 $600 $400 $200
$0
Option creates potential for upside return
Purchase call option
Purchase zero coupon
Zero coupon bond matures at $1000 per CD
Initial Investment
Investment @ Maturity
Benefits and features
?MLCDs provide diversification with exposure to a variety of markets that may include: equities, commodities, currencies and interest rates
?Investments have a fixed maturity, typically 3-10 years
?Investor's principal is guaranteed if held to maturity (subject to FDIC insurance limitations)
?Receipt of the performance of the underlying asset as measured by the original terms
?MLCDs have an estate put at par (may be subject to certain limitations)
?Minimum investment is typically $1,000
Risk considerations Performance
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.
Liquidity
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.
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.
Page 3 of 3 Market-Linked Certificates of Deposit, continued
Tax treatment
Investors who own an MLCD that is treated as a contingent payment debt instrument 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 taxexempt or tax-deferred account such as an IRA. For complete tax advice, investors should consult with their tax professionals.
Conclusion
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. ? 2018 All rights reserved.
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