Protecting capital… but there’s a price to pay

As the RRSP season came to a close early last month, there was a conspicuous shift away from mutual funds to the perceived safer climes of guaranteed investment certificates and, something of a new twist, to GICs linked to stock market performance.

Mutual funds reached new heights of popularity in the past few years as stock markets boomed and interest rates remained stuck at historic lows. Even the most conservative of investors, usually attracted to GICs, felt the pull to put at least some money into funds.

Enter the index linked GIC. To lure the conservative set back, many financial institutions created a variety of these products simply GICs whose rate of return is based on the performance of one or more of the world’s major stock markets.

And, thus far this year, the strategy is working very well: GIC sales are up as much as 40 per cent. Part of the switch stems from apprehension about the ongoing currency crisis in Asia and the resulting huge losses on North American stock markets last October. The recovery was quick, but people don’t soon forget such sudden, scary jolts. There’s no question, however, that index linked GICs are a big part of the resurgence of GICss well.

This type of GIC is similar to the regular kind in that you are guaranteed full security of the original amount you invest. However, instead of your return being based on a set interest rate, it’s linked to how well a particular stock market does over a specific period generally two or three years. If the market has registered a net gain by the time your GIC matures, your payment will be based on that rate of return. If the market has lost, you get no interest at all but your original investment is returned in full.

You will do better than with a normal GIC if the markets do well. If they lose, you will have missed out on two or three years of interest payments. If you want to play the market but can’t afford to risk your capital, it may make sense to invest anywhere from five to 10 per cent of your portfolio in these GICs. If you can’t afford, or can’t abide, the risk of earning zero on your money for two or three years, stay away.

These GICs have various restrictions you should examine carefully before investing. Most institutions offer two market linked GICs, one tied to the Canadian market, the other to key foreign markets. Some are “capped”, meaning you cannot earn more than 20 or 30 per cent no matter how high the market climbs. Others have a “participation” rate. If that’s 80 per cent, you would get only 80 per cent of whatever your market index were to gain.

Market linked GICs are very much a hybrid. In considering them as an investment alternative, compare them to other GICs, not mutual funds. Despite the fact they are based on market performance, they are very much like GICs in that they have a basic guarantee and their return is paid as interest, not dividends or capital gains. If held outside an RRSP or RRIF, you will pay full tax on whatever you earn.

If you hold them inside your registered plan, however, there’s an interesting advantage: Most of the foreign stock indexed GICs are RRSP eligible as Canadian content, making them a relatively safe way of increasing your RRSP’s foreign content beyond the 20 per cent limit.