Tuesday, May 4, 2010

3 Structured CDs With Big Potential.

Structured CDs (Certificates of Deposit) offer some upside under certain market conditions of environments where traditional CDs only offer safety of principal. In a general sense, the value of a structured CD is based on some underlying asset. This is usually done by the use of some kind of index to track that asset. Here are 3 structured CDs, based on 3 different indexes.

Inflation indexed CDs.


Tradition CDs are often touted as "safe investments" because the principal is guaranteed as is the interest rate. But the hidden risk to a traditional CD is the same as the risk to a savings account or a bond - inflation.

For example, if you bought a 5 year CD that was paying 2.63% (the average at the time of this post) and 2 years later inflation jumped to 5% for the remainder of the CD term, you would have actually lost money.

Inflation indexed CDs seek to eliminate this risk, by offering a lower rate but tying it to the inflation rate. For example, Wells Fargo offers a 5 Year CD that yields Inflation + 1.4%. As of last year, paid 3.25% until June 2012. After that, it resets to 1.4% above CPI. If the inflation rate in 2012 is as high as it was in 2008, you'd make over 5%. It could go even higher if 70's style inflation hit.

This sounds great - and it is for protecting against inflation - but you wouldn't want to put all of your money in this type of CD because:

  1. It's only guaranteeing you 1.4% return (after inflation).

  2. If inflation drops or holds steady at a lower rate, you may not really make much more than a traditional CD and you could even make less.


Stock or equity indexed CDs.


One of the tradeoffs of traditional CDs is safety in place of high returns. You simply aren't going to make as much from a CD as you can in the stock market. That's because there is much more risk in stocks than certificates of deposit.

But a new bread of CD aims to fix that, somewhat. Stock indexed CDs offer a stable floor for your return along with a potential upside if the stock market does well. For example, Harris Bank offers a 5-year stock indexed CD that yields the return of the S&P 500 returns. It's capped at up to 20% annually, and you don't get any of the dividends. The downside is that if S&P 500 goes down, investors only get to keep their principal.

Obviously, this is an upside when compared to what would happen in the stock market. For example, owning a fund that tracked the S&P 500 in 2008 would have lost you 40% of your money, whereas owning a stock indexed CD would have saved you from that 40% loss.

But when you compare that to a gain of 2-3% for a traditional CD, it's still a loss. It all depends on your benchmark and purpose in investing.

Currency indexed CDs.


Finally, we have the currency indexed CD, which usually offers a variable yield based on the currencies of one or more foreign countries. For example, Wells Fargo recently offered a 3-year CD that tracked the currencies of BRazil, Russia, India and China (BRIC countries).

At the end of the 3 year term of the CD, the holder is paid a yield based on whatever those currencies have gained against the dollar, plus 30%. If the dollar falls, investors earn 30% plus the difference. But if the dollar rises, investors get nothing.

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