Market-Linked Certificates of Deposit Overpriced, Report Says
Market-linked certificates of deposit are 7 percent less valuable than fixed-rate CDs, according to a report by a consulting firm.
Risks stemming from market gyrations, the issuer’s creditworthiness, and a small pool of buyers in the secondary market make benefits of the structured CDs “illusory” compared to fixed-rate products, according to the July 30 paper by the Securities Litigation & Consulting Group.
The report examined 2,072 market-linked CDs issued since 2005 that were tied to assets such as equities and commodities, rather than rates. The average term for the CDs, weighted by amount outstanding, was 5.8 years.
“The market-linked component of these CDs is sort of a teaser,” Tim Husson, a senior financial economist at the firm and one of the authors, said in a telephone interview. “What these actually pay out is very comparable, if less, than what traditional CDs pay out, which is namely not very much.”
Data on the size of the U.S. structured CD market is incomplete because the products, which aren’t considered securities, aren’t registered with the Securities and Exchange Commission.
Among the investments that Securities Litigation & Consulting analyzed were $5.51 million of five-year CDs tied to the Standard & Poor’s 500 Index, which Barclays Plc sold on Oct. 22, 2010. Investors receive returns tied to the S&P 500’s performance, with a cap of no more than 5 percent on quarterly gains though no limit on losses. The guaranteed minimum annual yield was as low as 0.25 percent.
The consultant calculated the CD’s value using midpoints for ranges given in the preliminary offering documents, such as for the cap. The firm made an estimate of 97.6 cents on the dollar, or 95 percent as much as a comparable fixed-rate CD. Investors have a 97.2 percent chance of receiving the minimum return, according to the report.
In May 2012, the Federal Deposit Insurance Corp. warned investors of potential risks of market-linked CDs that may have “extremely complex” formulas for how payments are made.
Banks aren’t obligated to estimate the value of their market-linked CDs. The SEC first asked issuers earlier this year to include such numbers for structured notes on offering documents.
While the FDIC insures the principal and accrued interest of CDs to a maximum of $250,000 as long as the investor doesn’t sell them, the guarantee doesn’t cover market-linked interest payments, which are subject to the issuer’s credit risk, according to the consultant’s report.
The other three authors of the paper are Tim Dulaney, Geng Deng, and Craig McCann, all of Securities Litigation & Consulting Group.
Banks create structured notes by packaging debt with derivatives to offer customized bets to retail investors while earning fees and raising money. Derivatives are contracts whose value is derived from stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather.
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