The Fed’s zero interest rate policy causes safety-first, income-seeking investors to consider investments they wouldn’t have paid any attention to a few years ago. One of those is the derivative CD, which goes under a number of different names. Basically it promises to give you a return, if any, tied to an investment or index. The return might be tied to a stock market index, gold, or almost anything else. If there’s no return, your principal is guaranteed. And since the CDs are sold by banks, they are insured by the FDIC.
These CDs are complicated, have high fees, lack liquidity, and many of the buyers probably don’t understand what they’re buying. The Financial Industry Regulatory Authority (FINRA) recently issued an alert about them. Bloomberg has a detailed look at these very popular investments ($25 billion of sales annually). They’re very profitable for those selling them, but maybe not so good for the buyers. Derivative CDs have their purposes and can be appropriate for some investors. But you have to understand that they aren’t higher-yielding alternatives to regular CDs. The yield isn’t know in advance and could be either higher or lower than what you’d earn on a regular CD. You also aren’t likely to be able to change your mind before the end of the contract.
“They are hugely profitable for the issuers, much more profitable than typical CDs, and they are poorly understood by retail investors, who will not be able to figure out how much profit the issuers are making,” said Frank Partnoy, a University of San Diego law professor and former Morgan Stanley (MS) derivatives trader. “The institutions that are selling them might as well be marketing CDs whose value depends on which team wins the Super Bowl.”
Sales of the investments may total $25 billion a year, Sean Gordon, who oversees distribution of market-linked CDs in the U.S. at Barclays Plc (BARC), said in a December interview. Banks sold a record 1,271 of them last year, according to StructuredRetailProducts.com, a database used by the industry, with some offering potential annual returns of as much as 24 percent by tying rates to everything from gold to Brazil’s real.
Bank revenue from the investments more than tripled to $99 per million dollars in retail deposits in October from $30 in January, according to Kehrer-LIMRA Research compiled from approximately 30 lenders, including Wells Fargo (WFC) & Co. and SunTrust Banks Inc.