Market Index Linked CDs (MILCs)

Introduction to MILCs

MILCs offer investors the potential for market appreciation, fortified by U.S. Government backed principal protection - a combination not found in either traditional stock or bond investments. MILCs deliver diversification from a unique structure, which investors cannot readily duplicate. With the foundation of an FDIC insured CD, MILCs investors tap the efficiency of Index investing, without the fear of loss.

MILCs are specialized forms of traditional Certificates of Deposit. They are issued at par, but rather than pay coupons, they pay interest at maturity in a lump sum based on the appreciation of a Market Index. Each MILC is linked to a specific Reference Index, for example, S&P 500, NASDAQ 100, etc. Whether or not the Reference Index appreciates, a MILC investor is assured the return of original principal when held to maturity (within FDIC limits).

Diversification

Diversification is widely recognized as a valuable investment tool for reducing risk. Its underlying notion is to hold a wide range of assets, which should react differently to specific market events. For instance, a rise in oil prices may harm manufacturers, yet benefit oil producers. By diversifying, the potential negative impact of events is lessened.

MILCs deliver diversity in two significant ways: First, through their linkage to Market Indexes, which by definition are comprised of a large number of securities within a specific market. Second, since the variety of MILCs include Indexes representing different markets, investors can utilize a combination of MILCs to diversify across multiple markets.

Index Investing

Another attraction to MILCs is the novel incorporation of Index investing, which had become an investment phenomenon. This surge in popularity is owed primarily to the efficiency of how Indexes are calculated, which makes them a preferred way to approach markets. Equity Index values, for example, are simply totaled from share prices. Therefore, they are not subject to the performance drag of sales commissions, uninvested cash, transaction costs, an operating expenses, which factor into Mutual Fund pricing. Investors should note, however, that since the structure of Equity Indexes is often based on market capitalization (larger companies carry more weight), a limited number of companies can have a material impact on performance. MILCs provide investors with a practical investment, tied directly to the performance of a Market Index.

FDIC Insurance

While standard Index investing exposes investors to all the risk of a market drop, the unique structure of MILCs eliminates this concern (when they are held to maturity). Built on the foundation of FDIC insured CDs, return of principal is assured at maturity. MILCs allow investors to reap the benefits of Index investing without the risk of principal loss. Note that the basic limit on FDIC insurance is $100,000 per depositor, per institution. It is possible through use of multiple institutions, joint accounts, and/or revocable trusts, however, to achieve far greater amount of FDIC coverage (in some cases exceeding $1,000,000).

Unique Structure

Essentially, MILCs combine Zero coupon bonds with long-dated Index options, which are normally not directly accessible by retail investors. If an investor were to substitute an Index fund in place of the options, a much lower market participation rate would result (likely less than 30%). Therefore, MILCs provide unique structure, that is otherwise typically unobtainable.

Who Should Consider MILCs?

Purchasers of MILCs are buy & hold investors seeking to participate in the price appreciation of a broad market index, while protection retaining against market decline.

Due to limited liquidity, MILCs are not suited for short-term trading. Further, no investor should purchase MILCs unless they are able to understand and bear the associated risks of market, liquidity, and yield. MILC investors should have the financial status and, either alone or with a financial advisor, knowledge and experience in financial and business matters sufficient to evaluate the merits and risks in light of their particular circumstance.

Computation of Interest

A MILC investor earns interest, at maturity, based on the percentage gain from the Initial Index to the Final Index value for the Reference Index. For example, if the Index rises 50% and the issue is not called, the interest payment on the CD at maturity would be 50% (assuming a participation rate of 100%. Note that terms vary among MILCs, and are specified in the Disclosure Statement for each particular issue).

Minimum interest is always zero. If a MILC has a call feature, interest may be capped and paid prior to maturity. Because of numerous factors that may affect the value of markets indexes, no assurance can be given that holders of MILCs will receive any interest (see "Interest" in the Disclosure Statement).

Tax Implication

Although holders of MILCs receive no interest until maturity, they are nonetheless subject to annual taxable income at the rate displayed in the Disclosure Statement (reflecting the interest rate for Fixed-Rate CDs of comparable term). The interest declared each year raises an investor's cost basis, thereby reducing ordinary tax consequences at maturity. Investors should consult their tax advisors in applying MILCs to their particular situation for U.S. Federal income tax, as well as state, local, foreign or other taxes.

Key Features

Features vary among MILC issues. Below is an overview of the major characteristics which may be present.

1. Call Feature
Some MILCs include a "call" feature, which provides the Issuer the options to pay off the MILC early according to a predetermined schedule of payoff and dates. For example:

                11% in one year            33% in three years
                22% in two years           44% in four years

The indicated amounts represent total interest as a percentage of par paid to MILC holders in the event of a call at the specified times. While a call may be a favorable indication that the reference index has performed well, the call feature can serve as a cap on the amount of interest which the investor receives.

2. Participation Rate
The participation rate specifies the percentage a MILC participates in the rise of its Reference Index. A rate of 100% indicates full participation in Index gains. (i.e.. if the Participation Rate is 100% and the Index rises 50%, the interest payment will be 50%).

3. Final Index Averaging
The Final Index may be based on the closing values of the Reference Index on more than one predetermined pricing date, such as the average of closing values at the end of each quarter in the last year of a MILCs life. Averaging the Final Index value captures the broad rise of the Reference Index, while avoiding the narrow risk of valuation on any particular day or time of year. It is important to recognize, however, that in a steadily rising market, averaging the Final Index results in a lower value than the absolute reference index level at maturity.

Example:

Assume an investor deposits $50,000 in a hypothetical MILC with quarterly averaging for the Final Index value. The Index closes at 1,500 on the day the MILC is issued, this becomes the Initial Index. In the last year before maturity, the closing values of the Index for each quarter are respectively: {2,300}, {2,400} {2,100} and {2,200}. The Final Index is then 2,250, the average of these four values. According to the formula, the MILC interest would be $25,000 (assuming a Participation Rate of 100%). This reflects a return on the original $50,000 investment of 50%.

4. Estate Feature
Life is uncertain, and MILCs are designed for security. MILCs typically offer a very useful estate feature commonly referred to as a "death-put", which provides optional redemption in the unfortunate event of death or legal incompetence prior to maturity. In these circumstances, the estate may redeem at par.

5. Early Redemption
MILCs generally offer early redemptions, allowing holders the option to redeem prior to maturity on indicated Early Redemption Dates according to procedures in the Disclosure Statement. Early redemption prices for MILCs are subject to many factors, and may be worth less than the deposit amount. ONLY MILCS HELD TO MATURITY ARE ENTITLED TO FULL RETURN OF THE DEPOSIT AMOUNT. Effort is made at all times to maintain a secondary market. Investors should be prepared to hold MILCs until an Early Redemption Date (if applicable), or full maturity.

6. Denominations
Convenient to asset allocation, MILCs are usually sold in increments of $1,000.