In recent years, banks have introduced a twist on the traditional guaranteed investment certificate (GIC). These products, known as market-linked or equity-linked GICs, are tied to the performance of the equity market and follow stock or bond indexes.
Market-linked GICs are a sort of hybrid investment vehicle: part GIC, part stock market investment. They guarantee the original principal, and offer the potential for higher returns, depending on how a specified market performs over a 3- or 5-year period.
In essence, the appeal of a market-linked GIC is that it comes with deposit insurance up to the eligible limits, and with the possibility of reaping the upside returns of the equity market. The potential gains with a market-linked GIC can be far in excess of what a traditional GIC would offer, which is why you may want to consider adding one to your investment portfolio.
How do market-linked GICs work?
All market-linked GICs are created differently, but they do share some common characteristics. First, the original amount invested is guaranteed up to the eligible coverage limits. Second, the return of the GIC is linked to how a specified market index ends up doing over the term of the product.
For example, take a 3-year market-linked GIC tied to the S&P/TSX 60 Index. This index, which is widely quoted, measures the stock performance of some of the largest companies in Canada. If the S&P/TSX 60 index climbs over the 3-year contract period, the GIC’s return will reflect this. However, if the market declines or even stays the same, there will be no return on the GIC at all. In this regard, market-linked GICs are very different from traditional GICs: to make any money, they require the equity market to rise.
With that being said, some market-linked GICs do offer a small amount of guaranteed interest, regardless of what the equity market does. For example, the TD Security Plus GIC pays a minimum interest rate of 0.10% for a 1-year term, 1.00% for a 3-year term and 3.50% for a 5-year term. (Note that these rates are for the whole term of the contract, not per year.)
Why returns are limited with market-linked GICs
For most market-linked GICs, the banks limit the potential return in one of two ways: participation rates and maximum returns.
This is the degree to which the GIC’s return will correspond to that of the equity market; it is expressed as a percentage. Here’s how it works:
You buy a 3-year GIC tied to the S&P/TSX Composite Index. (This is the most widely-known Canadian stock exchange). At the time of purchase, the market is at 14,000. By the end of the term, it has risen to 18,000 - that’s a gain of 28.57% over 3 years. However, if the participation rate is 60%, your return is limited to 60% of 28.57%, or 17.14% - that works out to 5.71% a year (not compounded).
Here is the formula for determining your return where there is a participation rate:
In our example, this becomes:
If there’s no participation rate, then the GIC contract may specify your potential return is limited to a maximum return. This stipulation is also expressed as a percentage. Here’s how it works:
You invest $10,000 in a 5-year GIC tied to the TSX with a maximum return of 20%. At the time of purchase, the market is at 14,000. By the end of the term, it has risen to 21,000 - that’s a gain of 50% (21,000 / 14,000 = 1.50) over 5 years. On a $10,000 investment, that should mean you’d walk away with $15,000 ($10,000 x 1.50) after 5 years.
However, your return is limited to 20% (expressed as 1.20 to include 100% of your original investment) because of the maximum return clause; this means you’d walk away with just $12,000 ($10,000 x 1.20) after 5 years.
Risks and opportunity costs with market-linked GICs
Market-linked GICs come with significant potential risks and opportunity costs. For example, if the equity market goes down and you receive 0%, you’ve lost out on the guaranteed return a GIC would have provided (say 1.75% a year). Alternatively, if the equity market goes way up, through either a participation rate or a maximum return, you could miss out on the full increase. In this case, it would have been better to simply invest directly in the equity market itself. As well the determination of the rate of return is established as a set point in time generally just prior to or at the maturity date and your rate of return is fixed only then.
- Market-linked GICs are typically non-redeemable.
- The fine print can be particularly important with market-linked products. Some contracts have clauses related to “extraordinary events”, such as market disruptions, where the bank may retain the right to modify how the GIC return is calculated.
- Some of these products are known as “mixed market GICs”, because the return depends on the “blended” performance of multiple markets (stock, bond, etc).
- Know the market your GIC is tied to. In the case of the Toronto Stock Exchange, three sectors (mining, energy and financials) make up the bulk of the index; this poses risks, because there is so little diversification.
- An important aspect of a typical investment in the stock market is the dividends paid to owners of shares. When you buy a market-linked GIC, you will not receive any dividends.
- For tax purposes, any gains on a market-linked GIC are considered interest income as opposed to capital gains; this tax treatment is different than holding the equity products outright but the same as holding a GIC.
- Banks often promote these products based on past performance, but even they will admit, in the fine print, that this cannot predict future performance.
Before buying a market-linked GIC, you need to ask yourself a few questions:
- Do you think the equity market is likely to rise over time?
- Are you ok with the possibility of earning nothing, if it doesn’t go up?
- Does a non-redeemable GIC suit your financial situation?
If you answered yes to all three questions, a market-linked GIC may be a good investment product for you to consider. However, if you answered no to one or more questions, a more traditional GIC may be a better option.