In troubled times, the wise investor will look not for the return on his principal, but for the return of his principal. If you would accept a maximum return of about 10% a year in exchange for never being able to lose money over the term of your investment, then structured CD’s are the product for you.

What’s this beast you ask? Never heard of them? Essentially a structured CD is a way of tying up your money for a preset amount of time in such a way as to guarantee return of principal, yet allow you to participate in the potential upside of any class of investments that strikes your fancy. These could be currencies, futures, commodities, equities, or a specific market sector, such as emerging markets or blue-chips.

Let’s assume you have $100,000 to spend. When you buy a structured CD, you are handing your money over to a bank. MAKE SURE THAT BANK IS FDIC GUARANTEED! If you ask me, if today’s US banks were forced to recognize the true value of their assets in real estate holdings, there would not be a soluble one among any of the big banks. But since the US government, through its FDIC guarantee, essentially protects investors for up to $250,000 per account, even in cases of bank failure, risks are relatively tolerable. It’s as safe as your savings account. (I know, some people don’t consider those safe, but that’s another topic altogether. )

From the start, you pick an investment class you feel could perform well over the next few years, but that you are not confident enough about to just outright buy. Maybe it’s gold, or copper. Or stocks. Or the Swiss frank. Once you’ve picked your sector, here’s what happens.

The bank essentially buys zero-coupon note, with the bulk of your money. These are bought at a discount and are guaranteed to appreciate back to par within a predetermined period. (Usually the banks will will buy government federal notes or agency notes, but a times they could be non-governmental paper. Remember that’s why you want the FDIC guarantee.) Let’s assume interest rates on 5 year bonds are around 3%. Investing in a zero coupon note, you would need $86260 for that to grow to $100,000 in five years. This leaves the balance, $13,740 to be invested in the sector you have chosen. Because the bank knows for sure that your $86260 will return $100,000 in five years, they can take bigger risks – using more leverage – to increase the returns on the balance of the money.

Specifically, they use options. By buying – never selling – options, the banks can potentially increase the return many-fold, but never lose more than the amount invested.

Because options are leveraged, a 1% rise in the asset class, could produce a 10% rise in the option’s value. So even though only 14% of your money is ever at risk, there is a possibility of matching the return you would have gotten if you had risked 100% of your principal in the asset class itself.

So if you invest in a structured CD invested in say, gold, and gold goes up over 5 years, you may see a return of as much as 10% a year without putting your principal at risk. That sure beats most bonds.

What’s the catch? Good, you’ve been listening to your mom, and she was right. Every investment has a catch.. So does this one. The catch on this one is that while you cannot lose money if you hold the investment to term , your upside is capped. Using our example, if gold is up 100% over 5 years, you will never make more than the cap, or 50%. The rest goes to the bank.

The other catch is that if you take your money out early, you won’t recover your full principal. The only part you’re sure to get back is the portion that’s parked in the zero coupon note. The remainder may be worth more, less or the same as you started, depending on the performance of the underlying asset in the interim period. After totaling these two amounts, before withdrawing it you must still pay
the internal sales commission stated in the brochure. This generally runs around 3 – 4 percent. (This does not apply if you leave the money for the full term.) So unless you’re committed to leaving your money for the term, you should usually avoid structured CD’s.

On the plus side, if tragedy hits, in the form of the grim reaper, your heirs are covered. Most structured CD’s have an estate feature, meaning the heirs can recover at least 100% principal, or better, upon your death, if they so choose, even if they do so before the CD’s term expires.

Let’s say you are an American who thinks gold is going to continue to trek upwards. But a part of you still holds out an ephemeral glimmer of confidence and trust in US politicians and the basic fortitude and common sense of your fellow man. So you think, maybe, just maybe, the government will balance its budget, people will accept to live within their means, savings will prosper, jobs will return and yes – gold will tank.

One strategy you might pursue would be to buy gold directly, and keep an eye on the exits, using stop losses and put options to protect your investment. But that takes knowledge, and effort and careful monitoring, and yes, a few prayers might help. If gold performs well, you might double, perhaps even triple your money in five years.

An alternative, far less complicated, would be a structured CD investing in gold. If gold doubles in value, your upside is capped by the bank at 10% a year, typically. So you’ll only make 50% (simple interest), while the bank will pocket that big difference. (Nice for them, huh? Whoever said life was fair.) But if gold goes up for 4 years, then falls off a cliff, you not only will get your principal back, but you probably already cashiered 30%-40% in interest payments in the preceding period.

Like the concept? Willing to accept the lower return as a trade-off for certainty of return of your principal? Then structured CD’s might be just the ticket for you.