As seen in an earlier post, traditional GICs offer security of principal with a low rate of return (in the current interest environment) for locking in the money for set time periods. The longer the term, the better the rate offered. Callable GICs provide a better rate than traditional GICs to compensate for the risk that the issuer retains an option to call the GIC after a set time period. Another type of GIC that is available is the equity-linked GIC, which we will discuss in detail below.
As the name suggests, an equity-linked GIC offers an investment return based upon the performance of a major equity index such as S&P/TSX 60 Index, S&P 500, or a weighted basket of international stock market indices. Such a GIC offers principal protection, while providing the opportunity for potentially higher returns than a traditional GIC. However, the return of an equity-linked GIC is variable as it depends on the performance of the underlying stock market index.
Equity-linked vs. Traditional GICs
As with other investment vehicles, the risk versus reward profile is applicable to equity-linked GICs also. These GICs seem to offer the best of both worlds – security of the investment and potential for higher returns. Nonetheless, in the event of the underlying equity index performing poorly, the GIC may not pay any interest upon maturity. So, the investor would receive his principal “as is”, while inflation may have eroded the purchasing power of that amount. Depending on the amount invested and term of the GIC, the erosion may be significant.
Let us consider an example to understand the impact better. Investor A has $1000 in an S&P 500-linked GIC for a term of 3 years, while Investor B has $25,000 in the same GIC for the same term of 3 years. Unfortunately, due to global crises, all equity markets, including the S&P 500 Index, perform poorly over the next 3 years. Both investors will receive their principal amounts back ($1000 for A and $25,000 for B) without any interest paid at maturity. What are their initial investment amounts worth after 3 years (i.e., upon maturity), if the annual rate of inflation remained constant at 2.5%? Investor A is left with $928.60 and Investor B has $23,214.99 in real dollars after accounting for inflation.
The above examples may portray equity-linked GICs in poor light, while making traditional GICs seem better. Traditional GICs offer a guaranteed rate of interest, albeit low, to aid in mitigating the impact of inflation. However, there is no chance to partake in stock market gains, if they happen. The bottom line is that both GICs face the threat of losing purchasing power to inflation. It is the responsibility of every investor to weigh the opportunity cost and decide if they prefer the low but guaranteed interest rate of the traditional GIC or the potential for higher returns offered by the equity-linked GIC, while running the risk of receiving no interest at the end of the term.
Typically, money invested in equity-linked GICs cannot be accessed until maturity. This is in contrast to most traditional GICs, where the funds can be withdrawn by paying a penalty in the form of a reduced interest rate or no interest receivable (for very short terms).
Editors Note – Market Linked GIC Downsides
- Market returns are based on a participation rate. Basically, this means that if the market does gain over the term, you will only be paid a portion of those gains.
- From what I can gather, market returns on these products do NOT include dividends, which can be a large portion of market returns.
Canada Deposit Insurance Corporation (CDIC)
CDIC insures investments ranging from $1 to $100,000. Investments could be in savings/chequing accounts, GICs, and other term deposits with a date to maturity of 5 years or less. So, equity-linked GICs with terms less than 5 years are eligible to be insured by the CDIC. However, please be aware that investments including GICs held at credit unions are not backed by the CDIC but insured by respective provincial bodies.
Are equity-linked GICs suitable for a portfolio?
As with any stock market investment vehicle (e.g. individual stocks, mutual funds, or ETFs), an investor with a long investment time horizon (several years) can consider holding an equity-linked GIC in their portfolio. Conversely, if an investor is using GICs as a short-term parking spot for money to be used as the down payment on a house, for a car, new furniture, etc., then it would be prudent to use traditional GICs or a savings account. As always, read the features and benefits section of the investment vehicle before committing your money.
Do you hold equity-linked GICs? What is your investment time frame? Did your decision to buy such GICs turn out to be fruitful?
About the Author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism. You can read his other articles here.