Tired of certificates of deposit yielding little more than 3% . . . but wary of investments that aren't government-insured?
Never fear: High-tech finance has an answer. Banks such as Bankers Trust, Chase Manhattan, and Swiss Bank have begun marketing a dizzying array of gee-whiz CDs powered by such "derivative" instruments as options, futures, and swaps. Like other deposits, the principal is insured up to $100,000 by the Federal Deposit Insurance Corp. But instead of a set rate of interest, the new CDs offer yields tied to the performance of everything from the Standard & Poor's 500-stock index to the value of Latin American debt.
Called "market linked deposits" or "guaranteed return on investment contracts," among other things, the CDs are the banks' way of getting around U.S. laws prohibiting them from underwriting mutual funds. In some ways, they're better than mutual funds, since they promise to return all or most of a depositor's principal upon maturity.
So far, banks have sold such CDs primarily to big American, Asian, and European depositors willing to plunk down $100,000 to $1 million or more. But now, smaller investors are getting a chance. Bankers Trust Co., for one, is offering these CDs in denominations as small as $2,000. Promising returns linked to the S&P, the certificates are being sold, much as mutual funds are, through Raymond James & Associates Inc., J. C. Bradford & Co., and several other regional stockbrokers.
NO NITROGLYCERIN. These products bear testimony to the increasing sophistication of financial engineering. Although simple in concept, their construction is extremely complex. A typical market-linked CD is basically a package of zero-coupon bank debt and long-term put or call options on an index. On a 5 1/2-year, $10,000 CD now being marketed to consumers, for example, Bankers Trust will use part of the deposit to buy a call option promising to deliver 100% of any gain in the S&P over the instrument's life. It will use the rest of the deposit to fund a discounted zero-coupon bond whose value will rise to $10,000 over the same period. So investors will get their principal back even if the S&P declines.
If the S&P climbs 100%, the deposit would double in value, for a 12.7% annual return. For investors who'll take more risk, Bankers Trust offers 5 1/2-year CDs that promise to return 110% of any S&P increase. But if the index is unchanged or down at maturity, investors will get only 90% of their $10,000 back. In any event, FDIC insurance will cover that 90%. Managing Director Joshua A. Weinreich says, "We don't want to sell nitroglycerin to our clients."
Investors could replicate some of these products by trading options. But brokers' commissions could wipe out potential profits. "We are offering one-stop transactions," explains Chase Manhattan Corp. Vice-President Kathleen T. Smith.
Bankers Trust says it uses hedging to avoid potentially big risks in offering payoffs linked to the Nikkei stock average, Latin debt, or the S&P. So to hedge an S&P certificate, BT may enter into swaps with other banks or buy equity-index futures or stocks themselves, using any dividends or trading revenues to help pay for the downside protection it promises.
Whatever the technique, the variety of market-linked instruments is expanding. Facing inroads from banks, Merrill Lynch & Co. is preparing to offer small investors 5-year instruments that resemble market-linked CDs in every way but their FDIC protection. Perhaps because of that, Merrill is pledging to pay 115% of any gain in the S&P. Even if the market falls, Merrill says it will repay investors' principal in full. Bankers Trust is mum on what it will offer next. But for yield-starved savers, the competition can't help but produce intriguing opportunities.