Guarantees? No thanks.
Canadians are a cautious bunch. How else can you explain the popularity of guaranteed securities? We don’t mind taking a chance — just as long as there is no risk involved!
I have been amazed at the number of new offerings of this type that have come across my desk since the start of this year. I suspect it is a hangover from the bear market of 2000-2002 but whatever the reason the folks on Bay Street who bet millions on new financial products have decided that we want to put our money into securities that promise to return it to us – someday.
Guaranteed products have been around since the late 1990s but the recovery of stocks in 2003 and, to a lesser extent, in 2004 seems to have been the catalyst for the latest outpouring of IPOs. People decided that they wanted some of the market action but, unlike the 1990s, their greed was tempered with caution.
Financial institutions saw this as a signal that investors would happily put money into growth-oriented securities as long as they included a guarantee of principal repayment. This resulted in a veritable deluge of guaranteed products. Although they vary in the details, they all operate on the same principle#8211; we’ll protect your capital while at the same time giving you an opportunity for profits far beyond what you could earn in a regular GIC. With five-year GIC rates still under 3 per cent at the major banks, the concept has appeal.
There are a wide variety of products from which to choose.
Some companies, such as Mulvihill Capital Management, launched a range of closed-end funds in the late ‘90s that guaranteed a return of principal at maturity, usually 10 or 12 years in the future. Most have been disappointments.
Banks, which have had only limited success in this area in the past, have rediscovered market-linked GICs and have been aggressively promoting them people who want to play stock markets around the world with, supposedly, no risk.
Mutual fund companies made deals with banks to issue guaranteed notes that calculate profits on the basis of how a specific fund or group of funds performed.
Most recently, when income trusts emerged as the hot product of the day, guaranteed securities were created to allow still-wary investors to obtain exposure to that sector.
Let me make my position on all these products absolutely clear. I don’t like them. I have not seen a single one that I felt was a good investment. To explain my skepticism, let’s look at the performance of Royal Bank’s index-linked GICs.
Royal Bank offers a three-year market-linked GIC that is tied to the performance of the S&P/TSX 60 Index. Investors have the option to lock in gains at the second anniversary. The bank also has a three-year global market-linked GIC with the payout based on returns from the German, French, Japanese, British, and U.S. markets over the period. You can find similar offerings with somewhat different terms at other financial institutions.
Interesting, but what are your chances of making money? Royal Bank has a useful market-linked GIC calculator on their website. To see how profitable these securities might be, I ran several scenarios. Here are the results. The profit column shows the gain over and above the return of principal as of April 30. Note that this represents the total cumulative return, not the average annual compound rate of return.
Type of GIC Purchase date Term Profit (per cent)
Canadian April 30, 2000 5 years 0
Global April 30, 2000 5 years 0
Canadian April 30, 2002 3 years 5.72
Global April 30, 2002 3 years 0
Canadian April 30, 2003 3 years 12.45
Global April 30, 2003 3 years 10.78
Canadian April 30, 2004 3 years 7.02
Global April 30, 2004 3 years 1.00
It’s worth taking a moment to study these numbers because they illustrate what a crap-shoot market-linked GICs really are. Anyone who invested in a five-year certificate at the end of March 2000 ended up with a return of zero. After that, Royal dropped the five-year option and only issued three-year certificates so I plugged in the numbers for an investment in both the Canadian and Global GICs on April 30, 2002. At maturity, the Global GIC paid nothing. There was a small profit on the Canadian GIC but it worked out to less than 2 per cent a year over the term.
The lucky investors were those who put their money in at the end of March 2003. In both cases they were sitting on respectable (but not great) gains two years later and had the option to lock in if they wish. But anyone who closed the book at that time wouldhave been left with an investment that earns no profit over the next year. In that case, they will end up with an average annual compound rate of return of between 3.5 per cent and 4 per cent for the three years, depending on which GIC they chose. That’s not lot when you consider the risk involved.
While I understand the appeal of guaranteed securities, they are not risk-free as people seem to believe. It’s simply a different kind of risk. I have yet to find one in which the pros outweighed the cons and not a single reader had ever reported to me that they made a lot of money on a guaranteed security.
At least if you invest directly in the stock market or in mutual funds, you can exit at any time. Your money is not tied up for years, perhaps earning nothing while you wait.