The Seductive Draw of Market-Linked GICs: Know What You Are Getting Into
Every once in a while in my earlier career, I was approached by people who were interested in market-linked Guaranteed Investment Certificates (GICs). These are investment products that protect your principal but give you the opportunity to participate in the growth of the stock market. It sounds like a great deal, doesn’t it? You get the potential for market-like returns with none of the risk. It was not my role to advise people whether or not these were good investments; my responsibility was to let people know of the possible returns.
Unpacking the Market-Linked GIC
The Basic GIC
Let’s start with the basic GIC. Imagine you have $10,000 that can be set aside for 5 years. You want a guaranteed safe return. Assume you can find a GIC that returns 1% compounded annually, over five years. That’s not much of an interest rate, but it’s not untypical these days in the latter part of 2020. Table 1 illustrates the result.
The Market-Linked GIC
A Market-Linked GIC behaves quite a bit differently. Yes, there is a guarantee in place, but it is only for a minimal amount. One that is representative of this type of product links the return to the US S&P 500 stock index. It offers a guaranteed 1.00% return. Given the rates of GICs these days, that sounds about right. However, that 1.00% is over the full five years. On an annual basis, that works out to 0.2003%. On the upside, there is potential for a maximum return of 10%. Again, be aware. That 10% is spread over those same five years. That number is the reason why these GICs are interesting to many people. Just to be clear, though, that is considered bonus interest that is paid at maturity. In other words, the market must be up at least 10% from the date you purchased the GIC to the date of maturity, in order for you to collect the maximum return. For illustration purposes, though, I will show the return on an annualized basis in Table 2 below. The annual compounded interest over five years works out to 1.9245%.
Clearly, If the market works out, you are going to do better with the maximum return of this market-linked GIC than you are with the regular GIC as shown in Table 1. On the other hand, if the market swoons to a big drop just as your GIC is maturing, say for example in March of this year, you might be stuck with little more than the minimum.
Build Your Own Market-Linked GIC?
This idea was inspired by Dan Bortolotti, who wrote an article entitled, “A Homemade Principal-Protected Note,” in MoneySense Magazine back in 2012. A principal-protected note or PPN, works very much like a market-linked GIC.
Let’s imagine you have access to the standard 5-year 1% GIC mentioned earlier. You still have your $10,000. You want to at least get back the minimum that the market-linked GIC offers, so you use $9,610 of the $10,000 for the GIC. At 1%, compounded over 5 years, you get $10,100 back, guaranteed. With the balance of $390, you buy a US equity mutual fund. The details are laid out in Table 3 below:
The column labeled Return of US Equity Fund %, indicates the percent returns of the last five years, with the year 5 return of 9.65% representing the “year-to-date” return of the fund as of September 30, 2020. Although, not quite as good as the maximum return available from the market-linked GIC, you get back more than your guaranteed minimum, and with that small investment in the mutual fund, you do considerably better.
This next table also includes the purchase of a mutual fund. If you followed the stock market this year, you will recall that, in the wake of the onset of the COVID-19 pandemic in mid-March the markets dropped substantially. Let’s assume that for 2020 the markets stayed down, concluding with a 30% loss. Table 4 presents what that scenario would look like:
Even with that 30% drop in the final year, you still come out with a return quite a bit better than the minimum. In fact, this arrangement gives you an almost certain guarantee that you will exceed the minimum as it is highly unlikely that the mutual fund will fall to zero.
As you review these tables, you may wonder whether market-linked GICs make any sense for you. They make great sense for the banks. Take a look at Table 5, which shows the return of the US mutual fund by itself.
You set aside $10,000 for five years in order to receive a guaranteed return of $100 and a potential return of $1,000. In the meantime, if you had put all of your money into a US mutual fund, you could have received $6,981 over that same five-year period. Granted, it is not a guaranteed sum, but this illustrates that the link to the stock market in these market-linked GICs is pretty weak.
A guaranteed return of 10% over five years does not even equal 2% per year. Although impossible at the major banks, you can still get a rate at – or close to – 2% for a regular GIC at one of the online financial institutions. If you need a guaranteed source of return from your money you would probably do better to simply stick with straightforward GICs. And, if your time horizon is over five years, you may want to consider diversifying your investments beyond beyond the guaranteed world.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.