In recent months, things have been going well for the Canadian economy. The dollar is up, stock markets are performing well, and the unemployment rate is at its lowest point in 40 years. As a result, interest rates have been going up.
We normally think of interest rates affecting mortgages and loans, but GIC rates have also been in the news. While some GIC providers like have raised their GIC rates recently, many financial institutions, including some of Canada’s biggest banks, haven’t passed on higher rates to their customers.
If you’re looking to get more out of your GICs, there is another option: the market-linked GIC.
When you invest in a GIC, you lock in your money for a specified length of time in exchange for a guaranteed rate of interest. It doesn’t matter what happens in the market or economy; you know at the time you make the investment exactly how much it will be worth at the end of the term. And if the provider has CDIC insurance (most banks do), your deposits are backed by the Government of Canada. It’s virtually impossible to lose money on a GIC investment.
But the downside to this arrangement is that if interest rates go up, your existing GICs are already locked in, and you don’t get to enjoy the benefit of higher rates. Anyone who invested in a 5-year GIC at this time last year when the best-in-market rates were around 2.50% will continue to earn 2.50%, even though the best GIC rate on new 5-year GICs is currently 3.25%.
That’s where the market-linked GIC comes in. Instead of locking in a set interest rate, the market-linked GIC pays a return based on the performance of certain indices (like the S&P TSX 500) while guaranteeing you won’t lose your initial investment if the market goes down.
Take, for example, the BMO Canadian Market GIC. When you invest in this product, you commit to a term of 3 years, and earn 50% of the total gains of 60 of the largest Canadian companies, as represented by the S&P/TSX 60 index. If the index goes down over your term, your principal is still guaranteed so there’s no chance you can lose money. If the index goes up 10% over your term, you get a 5% return on your investment. If the index goes down 10% over your term, you still keep 100% of your original investment. It’s a win-win.
Some market-linked GICs also guarantee you a minimum return on investment. The BMO Market Plus GIC, for example, currently guarantees a minimum return of 3.00% over the course of your GIC term.
There are some drawbacks to market-linked GICs, however.
Locking your money in to a market-linked GIC prevents you from making changes or rebalancing your portfolio like you would be able to do if you invested in a fund directly.
There are also minimum investments and other fine-print issues to watch out for. Some market-linked GICs stipulate a maximum return that limits your earnings if the fund your GIC is invested in performs extraordinarily well.
And there’s an opportunity cost that comes with market-linked GICs. If you invest in a market-linked GIC and the fund gains value, you only keep a portion of that gain. The rest goes to the bank. The three-year average return of the S&P/TSX 60 fund as of December 31st, 2017 is 6.59%. That means A 3-year market-linked GIC paying 75% of gains would be expected to return an average of 4.94%. That’s higher than the best rate for a regular 3-year GIC, but leaves you to choose between leaving money on the table if the index performs well, and giving up the security of a regular GIC for only a small incremental return.
The choice ultimately comes down to your own financial situation and tolerance to risk. And as with all investments, past performance is not an indicator of future success, and your mileage may vary.
If market-linked GICs sound appealing but you’re not quite convinced, you may want to know about some of the alternatives to market-linked GICs available.
First and foremost is a regular GIC. Regular GICs pay guaranteed returns and are some of the safest investments available to Canadians. But returns are typically equal to inflation, and banks are far less eager to pass on interest rate increases to GIC customers than they are to borrowing customers. Still, if you’re looking for an extremely stable and predictable investment, you can’t beat the GIC.
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You can also try low-cost exchange-traded funds (ETFs). These funds follow the same markets as market-linked GICs and have low management costs compared with mutual funds. You can buy in or cash out at any time, and if the fund goes up in value, you get to keep the entire return on your investment. But if the fund loses value, there’s no safety net to prevent you from losing money.
But if you’re willing to give up potential returns in exchange for mitigating risk, market-linked GICs are an excellent option. They have the potential to out-earn regular GICs, and they’re guaranteed not to lose money. And with a wide variety of funds you can choose to invest in, market-linked GICs could be a worthy addition to your portfolio.