Market-linked GICs: worth the risk?

Interest rates may be about to rise but GIC investors aren’t seeing the impact of that yet. The big banks are still paying only 3.4 per cent on five-year notes, which is not going to get anyone excited. The continued low rates plus the strong performance of stock markets over the past 18 months have sparked a renewed interest in market-linked GICs.

I have received a number of inquiries from readers about them in recent weeks, including the following one:

“I saw some information on the TD website about Market Growth GICs with a guarantee on the original deposit amount. How do I find out the returns I may get from these, and is it a good idea to put my money into this type of GIC?”

Market-linked GICs base their payouts on stock market performance. The formula varies from one financial institution to another, so I’ll focus on the TD Canada Trust Market Growth GIC that our reader referred to.

Types of funds
They are available in three-year and five-year terms. The minimum investment is $1,000, or $500 if the GIC is held in an RRSP. Your original principal is indeed guaranteed to be repaid at maturity. TD Canada Trust offs three types of market-linked GICs.

GIC Plus. The return on this GIC is linked to the performance of the S&P/TSX 60 Index. This tracks the stocks of Canada’s largest 60 companies, so it is the nearest thing we have to the Dow Jones Industrial Average.

U.S. GIC Plus. In this case, the return will be based on the performance of the S&P 500 Index in New York, which is made up of America’s largest 500 companies.

Global GIC Plus. Those who select this option put their hopes in a basket of international stock indexes, representing the G7 countries: Canada, the U.S., Great Britain, France, Germany, Italy, and Japan. The benchmark is the TD Global Index.

It’s important to note that both the U.S. and Global GICs are considered as Canadian content for registered plans and there is no foreign currency risk.

Market-linked GICs pay no interest until maturity, so if steady cash flow is needed they are not suitable. When the term is up, the amount of interest will be calculated on the basis of the increase in the level of the benchmark index during the time the investor held the note. So there is no way of predicting the amount that will be paid.

Next page: Look out for the cap

The TD notes have a cap on the payment. In the case of the three-year GIC Plus, the maximum is 21 per cent. For the other two GICs, it is 20 per cent. This means that no matter how well the benchmark index performs, the maximum potential annual compound rate of return is about 6.5 per cent.

The cap is more generous for the five-year term, with the best potential offered by the Canadian-based GIC Plus where an investor can earn as much as 60 per cent (about 9.8 per cent annually, compounded). Next best is the Global GIC Plus, with a 50 per cent cap (about 8.5 per cent compounded annually).

The worst five-year choice from a total return perspective is the U.S. GIC Plus, which is capped at 43 per cent (about 7.4 per cent annually).

Investors have to ask themselves whether these maximum potential returns are attractive enough to forego three or five years of cash flow and the risk that if markets perform badly (as they did from 2000 to 2002) they could end up receiving nothing but their principal back. Also, any interest earned will be taxed at full rate if the GIC is held outside a registered plan. The earnings on the GIC do not qualify as capital gains as one might expect.

All in all, I don’t like the odds. There are other investment choices that are much more attractive. So these securities are only suitable for investors with a gambling instinct, although in that case why not just buy the iUnits that track the S&P/TSX 60?