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Ask Lane Your Own Question

Lane
Lane, JD, CFP, MBA, CRPS
Category: Finance
Satisfied Customers: 4055
Experience:  Providing Financial, Tax & Business advice since 1986
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Whate about CDs linked to indexes like the Dow Jones or S&P

Customer Question

Whate about CDs linked to indexes like the Dow Jones or S&P 500? How do CDs which don't pay interest until they mature?
Submitted: 1 year ago.
Category: Finance
Expert:  Lane replied 1 year ago.

Lane :

Sure, those kinds of hybrid products can make sense ( especially for someone looking for guarantees), just be sure that you understand the ins and out of the contract ... Many time there are TWO THINGS that you need to watch for (1) a "participation rate," which means that even of the S&P 500 rises by say 10% you only get a % of that ... like, if the S&P goes up by 10%, you only make 4% ( IF it does ... if it only goes up by 4, you get 1/2 of a percent) and (2) the guarantee of principal is only for the beneficiary ... rememner. in an environment where we don't even know if the market is going up by 5 % in the nest few years... why would they give you 10%?

Lane :

Sorry to be a killjoy, but typically, if you want a guarantee... today... the guarantee will not be higher than the product provider, themselves, can get in the market.

Lane :

Still with me?

Customer :

Where did you go? I am trying to find out if a CD linked to an index like the Dow Jones or S&P 500, which don't pay interest until you cash it in would be a good idea. Also, do fixed income funds get clobbered when interest rates go up? I am still looking for preservation of capital and some income, with the ability to raise cash in five years.

Lane :

SO ... sorry ... System is really glitchy tonight

Lane :

I am trying to find out if a CD linked to an index like the Dow Jones or S&P 500, which don't pay interest until you cash it in would be a good idea ... Yes, as long as you understand that tney NEVER give you all of what they market wne t up BY .. that is they usually have what's called a participation rate, where is the market goes up by 7 you get 4

Lane :

Also, do fixed income funds get clobbered when interest rates go up? ... Yes, always ... if new bonds are coming out at 5% why would I buy your bonds at 4% ,,, I would but only at a discount that makes my real return 5% ... that's the whole inverse relationship between interest rtes and bonds

Lane :

I am still looking for preservation of capital and some income, with the ability to raise cash in five years. again, in THIS enviroment... treasurie a 2.73% are the only real guarantee

Lane :

You may want to look at a 5 year fixed annuity ... I really dont like variable annuities, but again, in THIS environment, these insurance companies are offering some guarantees ton FIXED annuities that are a LITTLE above what treasuries can do ... MIGH be a thought

Lane :

Here's an excellent article on indexed CD's ... you;ll se ther are no guarantees her either

Lane :

hope this helps

Lane :

Lane

Expert:  Lane replied 1 year ago.
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Expert:  Patrick O. Oswald replied 1 year ago.
Market linked CD's are not very common. You would be better off putting the money you need in a 3-5 year CD, and the balance into a Exchange Traded fund. There are some ETF's with great yields now.. 7% ++.
Expert:  Lane replied 1 year ago.

Hi there Chris,

I completely disagree with the claim made above.

Further, one should understand the difference between yield and total return.

Yield is interest or dividends. See this: http://www.investopedia.com/terms/y/yield.asp

If you wanted to take any principal risk at all, then a portfolio of VERY diversified investments that actually shows a standard deviation low enough to provide some true diversification MIGHT be a way to go. (and again could only achieve rates claimed above by adding growth of principal AND yield, OR is such a below investment grade bond that the default risk would be atrocious)

But for a five year window? No ... not appropriate at all and based on your questions, information provided, and past investment experience, a completely unsuitable recommendation.




By the way, because this site isn't registered as an investment adviser with the SEC, we can't make the kind of specific recommendation made above anyway (under the registered investment advisers act of 1940) ... you'll notice that my discussion above discusses alternatives, and some general education about those alternatives.




MOST important, however, is the fact that in today's interest rate environment NOTHING is yielding the kinds of rates claimed above (a blended portfolio with some equities, if you get lucky about when you pulled them out - maybe) ... but that's not yield.

AND for a five year window? Completely unpredictable, and inappropriate ... quite honestly, dangerous, given your intended goals for this money.

Now, if some of those dollars are going to be there 10 years or more, then it almost becomes inappropriate NOT to recommend SOME equities ... but even then, the investor needs to understand the risk.



As you go about your search out there...be very aware of the credentials of those offering "ADVICE."

Those with a SERIES SEVEN securities license, for example, (even though some of them don't even realize it) owe more loyalty to their broker/dealer than to you. They DO NOT work for you. They REPRESENT a broker/dealer ... that's why they're called brokers.

The series 7 license is a registered rep's license ... and the entity being represented is a broker/dealer NOT YOU. (Next time you run into someone that has registered rep on their business card, or the card says "securities offered through ...") tell them to go read their contract before making the claim that they're actually offering advice....because all they can offer you BY LAW is the opportunity to BUY something from them.




If you want good, unbiased advice from a fiduciary who represents YOU, sit down with a CFP who is ALSO a fee-only financial adviser (These folks refuse to take commissions), which eliminates the conflict of interest that permeates the registered rep's business model. They represent only you.

Here's a good place to start: http://napfa.org/

Use the find an advisor search (right there on the front page), find a fee-only person in your area, give them a call and ask them about an investment that pays a 7+ percent yield ... once they fall out their chair laughing, they will best be able to help you understand the trade-offs that exist in today's environment.




Two final thoughts:

(1) Whether it's a CD, an annuity or any other (Index linked hybrid, such as the one you mention) you will get a guaranteed rate that is Very Low single digits, along with a PARTICIPATION in an index, such as the S&P 500, meaning that you will only get a portion of that return ... AND it will likely come with a CAP - This is the price you pay for the guaranteed rate of - in today's environment, 1 or 2 %). You'll never get anything close to what the index actually does.

(2) In today's environment you'll only be able to achieve the kinds of returns claimed above, but take substantial risk .. even long bonds are barely getting to 4's. You'll either have to blend in equities or it it's actually doable with yield is would be with a junk bond, junk bond, fund, or a junk bond ETF ... and not only will there be incredible default risk there, guess what happens to bond PRICES (principal amount invested) when rates go up - and that's the only place they can go from here - those bond prices go down.

Here's an excellent article on why that happens: http://www.investopedia.com/ask/answers/04/031904.asp



If it sounds to good to be true ...


Lane

(Be careful out there)






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