Market-linked GIC

Market-linked GICs (Guaranteed Investment Certificates) are a type of structured product that combines the security of principle of a GIC with some participation in specified equity market returns. They are also known as index-linked GICs and are higher-risk investments than normal interest-bearing GICs, which are very low risk.

Market-linked GICs appeal to investors who would like to enjoy potentially higher returns (compared to normal interest-bearing GICs), but are afraid to lose money in the stock market. In other words, these products "appeal simultaneously to our greed and our fear", which may help explain their popularity. They are typically sold in bank branches.

"Keep in mind that financial institutions have designed these products and have deemed them attractive enough to want to sell a lot of them. In other words, they will tend to offer products when they are confident that the odds will be tilted in their favour – which may be at odds with what’s best for end investors"

Dan Hallett

How they work

The terms of market-linked GICs are typically three or five years, although some recent issues have ranged from two to six years. The products are non-redeemable. If the underlying stock market index has negative returns over the period, the investor in a market-linked GIC will get their money back, i.e. the capital is guaranteed. That represents a 0% return in nominal terms, i.e. before inflation, but a negative real (after-inflation) return.

If the underlying equity index has a positive nominal return over the period, then investors in market-linked GICs get a portion of that equity return, but not all of it. This is because:

• Dividends, which can represent a significant portion of the equity returns, are often excluded from the calculations. Instead, only the price increases are considered.
• The participation factor -- what percentage of the stock index return the investor will actually get -- is discretionary and set by the financial institution at the time of GIC purchase
• The calculation may involve the average of the index level during the final year, rather than the end-of-year price
• Sometimes there is a hard cap on the return

You should be careful to fully understand the terms and conditions of the GIC before/if you make a purchase: read the details.

Because these products tend to be complex, lack transparency and you cannot control when you sell your investment, one financial institution, ATB Financial (formerly the Alberta Treasury Branch), has stopped selling them.

Taxation in non-registered accounts

Index-linked GICs are not normally taxable until maturity, when the exact return is known and paid, at which point it is fully taxable as income. This makes them tax-inefficient relative to true exposure to the same equity index (e.g., in an index mutual fund or index exchange-traded fund (ETF)), because:

• Dividends and capital gains are taxed more favorably than interest and regular income
• If holding an equity index fund or ETF, you don't have to sell it after 3-5 years, and the capital gain taxes are only triggered when the securities are actually sold

Some market-linked GICs have a minimum interest guarantee which requires investors holding them in non-registered accounts to report and pay tax on the minimum interest guarantee each year.

Returns and standard deviations

Edwards and Swidler looked at similar products from the US and calculated their hypothetical returns from 1981 to 2004. The average returns were much lower than those of the S&P500 index (the stock index to which the US products are linked), and more similar to that of government bonds, but with more volatility than those bonds.

Home-made market-linked GICs?

Milevsky questions why these products exist in the first place if investors are rational. He then explains that they can be valued as a combination of zero-coupon bond and call options on the underlying stock index (see also ). If an individual investor theoretically had access to institutional pricing on bonds and options, then the exposure of index-liked GICs could be replicated "at home", more cheaply then by buying the structured product (the index-linked GIC). Suppose the capital to invest is $10 000. First, the investor would purchase a zero-coupon (stripped) bond that paid exactly $10k at maturity, in five years. That means that regardless of what happens to the stock market over that period, the capital is protected (in nominal terms). If the interest rate on that zero-coupon bond was about 4.5%, it would cost about $8000 to purchase, leaving $2000 to buy the call options on, for example, the S&P/TSX or the S&P500 indices.

In practice, retail investors don't have access to institutional pricing on bonds and options. The best that can be done is perhaps to buy enough of an interest-bearing GIC to protect the capital, and invest the rest in equities.

Alternatives

Over a long enough period (decades), equities or balanced portfolios (mixes of equities and fixed-income, like bonds and regular GICs) are very unlikely to have negative nominal returns (see Canadian asset class returns 1900 - 2000). The capital protection of index-linked GICs is therefore costly and not necessary over a long enough time frame. Instead, investors could simply buy fixed-income products (e.g., normal GICs, bond ladders, bond index funds, bond ETFs ...) and equities (e.g., index funds or index ETFs) in proportion to their chosen asset allocation. See Portfolio design and construction.

External links

• MoneySense, Market-linked GICs: The pros and cons for investors
• Rational Reminder Podcast, Episode 255: Structured Products