Market-Linked GICs: Have your stock cake and eat it too

Index-linked GICs give risk-averse investors upside on stocks

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From the June 2014 issue of the magazine.

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Interest rates are low, yet people still tuck money away in money market funds. In the U.S., where stock markets are near record highs, more than US$2.5 trillion, almost 20% of all funds, is still parked in money market funds. It earns safe, meagre returns that are only slightly better than putting money under a mattress.

But where should one invest? Choose bonds and you run the risk you may lock in to low rates just as they move higher. You could lose value as bond markets adjust. As for stock markets, an old friend used to say trees don’t grow to the sky. At some point they stop. Stock markets could even go down from here. Investing is a dilemma.

What if you could preserve capital and still participate if stock markets rise? The recent RRSP season saw a slew of advertisements that touted ‘Market-Linked Guaranteed Investment Certificates’ with various names that played on the theme of ‘smart.’

These are GICs that offer the security of a traditional GIC one can get at a bank. The difference is payments are based primarily on the performance of stocks. The best part is the incremental return accrues only if markets rise rather than fall. Sounds too good to be true, like ‘having your cake and eating it too,’ doesn’t it?

This type of product has been around a while, but seems to have gained popularity recently. Investors kick themselves after missing out on the returns in the stock markets, especially last year. However, the global financial crisis that crushed many portfolios has resulted in a more cautious approach by many, if not most.

The biggest bank in the country, RBC, offers several ‘MarketSmart’ GICs. Principal is guaranteed, so at a minimum you get your money back at maturity. There is also, sometimes, a minimum guaranteed return. Typically it’s not much, but better than nothing. And you have the opportunity to get a higher rate of return, based on how various stock markets do.

What’s the catch? If there’s an upside to markets, there may be a cap on the return passed on to investors. If stocks scream higher, you’re limited to a maximum, which is a function of the GIC’s maturity and the index it’s tracking. For example the RBC US MarketSmart GIC tracks the S&P500 index, capping out at 5% if you invest for two years. In the interim, you’re guaranteed a minimum 0.5%. If willing to commit for a longer time, five years, the maximum is 25% and minimum 5.25% (as of March 25th). For contextual purposes, in 2008 the S&P was down 38%, but was up 30% in 2013. From early 2008 to the end of 2013, the index was up 25.8%.

Most financial institutions offer variations on this model. Sometimes there’s a guaranteed minimum return, sometimes not. Usually there’s a set maximum return, on the order of 2% to 3% per year, but some products offer unlimited upside returns. Those are set as a percentage of the return of the underlying index. For example, if an index is up 5% you may receive only two thirds of that, or 3.3%. If up 30%, you get 20!

Too good to be true? Some think so. According to InvestRight, a program of the B.C. Securities Commission, these products are protected by the same entity that protects any bank deposit, CDIC. They are a no-fee alternative, which everybody likes.

But selling them easily before they mature is problematic. Typically you get back only your principal.

Perhaps the biggest issue most people have with these products is that returns are unknown and not particularly flexible. That makes them hard to incorporate into financial plans. Markets fluctuate, so you’re at the mercy of the maturity date and flexibility is sacrificed. But isn’t that the whole point? Slightly higher risk with potentially better returns and knowing you can never lose principal. Besides, if investors were any good at market timing, they wouldn’t be looking at this product anyway!

My personal bias is that many of these products track indexes with which I’m already comfortable. Why would I want to earn interest based on an index that tracks a bank or utility index when I could just buy an ETF that tracks the same index? The ETF spins off dividends, often more than 4%, and is taxed favorably. By contrast, the GIC return is highly taxed as interest income. The GIC return is based on index numbers you may read in the papers, and which don’t include dividends as part of the return.

On the other hand, these type of GICs provide relatively low-risk access to broad U.S. or global markets to which many investors want exposure. They’re not bonds, but they do fulfill the fixed-income component for asset allocation.

To sum up, market-linked GICs are moderately complicated and lack some transparency and flexibility. But they give me the comfort of knowing I can’t lose money. At the same time, I am, and to a maximum, invested in the stock market.

As Marie Antoinette once said “Let them eat cake.”

Pat Bolland is a veteran financial broadcaster currently with Sun News Network. His Twitterfeed is @patbolland.

2 comments on “Market-Linked GICs: Have your stock cake and eat it too

  1. I think the complexity of these products leave a lot to be desired. This strategy may be fine for small balances say under $25000 but if someone wants to implement this strategy on their own there is a fairly easy way.

    For example if someone has $100000 to invest for 5 years they could put $87600 into a 5 year term at current rates (2.70%) and take the remaining funds and put them into the market. That $87600 will grow to $100000 meanwhile the other $12400 can be invested.

    The benefits are multiple. 1) They have access to that $12000 amount if need arises 2) if the markets works for them they participate in the full return. 3) They can add additional funds to the investment. 4) The earnings on the investment account will likely be more tax efficient.

    Reply

  2. The bottom line is that right now the highest 5 year GIC is paying 3.00% annually and if compounded, it is a total of 15.927% interest over 5 years. If you do not need your money in 5 years and are using it for long term needs, decades down the road, you can buy longer term provincial strip bonds yielding around 4.00% these days which with compound interest works out to 21.166% over 5 years.

    The point about taxation of GIC’s and interest is valid but TFSA’s make these a non issue and RRSP’s are taxed all the same no matter if they have ETF’s, stocks and other investments paying dividends, creating capital gains and interest from GIC’s, bonds, strip bonds etc.

    A very prudent and long term financial plan of maximizing RRSP’s, RRSP refunds, RESP’s and TFSA’s annually for most Canadians would work out great even at 4.00% annual yields compounding annually.

    2 adults spouses or common partners living in the same household that maximize say $15,300 in RRSP’s and $11,000 in TFSA’s invested at 4.00% annual yields compounding interest based on a combined gross $85,000 annual income would have after 37 years from 30 to 67 years old about $2,234,720 in total.

    Remember, 42% would be tax free income, TFSA’s and 58% would be taxable income, RRSP’s. This is a good balance and taxing position to be in.

    This is not even including the annual RRSP tax refunds of about $4,700. Even in a non-registered accounts, this would be about $270,000 to $300,000 in 37 years after all income taxes paid with a 30% to 34% income tax rate.

    Some RESP’s and future TFSA’s, RRSP’s could be used to shelter some of these income taxes and make hem income tax free. Credit cards cost you interest, mortgages cost you interest, car loans cost you interest, lines of credit cost you interest etc. but when it comes to your investments interest is supposed to be bad for you.

    People think carefully what you hear, see, read about when it comes to your hard earned money. Nobody will take better care of your own money than yourself.

    Reply

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