Safe and secure?

Index-linked guaranteed investment certificates allow stock market participation and guarantee your investment. Too good to be true? Weigh the pros and cons.

If keeping your assets safe and earning a competitive rate of interest are among your key objectives, guaranteed investment certificates (GICs) are a good choice for your portfolio. But sitting on the sidelines while financial markets skyrocket can frustrate even the most conservative investor for whom a safe return is an overriding consideration.

Index-linked GICs were created by financial institutions in their attempts to entice investors wary of market volatility yet disenchanted with the low returns on deposits and other ultra-safe instruments. Generally, they’re available from the same issuers who offer conventional GICs, including banks, trust companies and credit unions, as well as investment dealers and mutual-fund companies and may be sold variously as “market-growth”, “market-linked” and “stock-index” GICs.

The return you earn from these investments depends on the performance of the underlying market. Most are based on stock markets, including popular indexes such as the S&P/TSE 60 inde which is made up of the 60 largest companies on the Toronto Stock Exchange, and the S&P 500 index of U.S. stocks. Other index-linked GICs base returns on a blend of world stock markets.

Positive aspects

Like traditional GICs and other term investments, index-linked GICs offer a guarantee on your principal. Also like their more conventional counterparts, stock-indexed GICs are available with various terms.

It’s an appealing concept. You get to participate in potential market gains and you’re guaranteed to get your investment back even if markets are in the tank at the maturity date. And when markets are soaring, it’s easy for index-linked GICs to outperform the staid returns on conventional GICs. As well, index-linked GICs are considered domestic content for registered plans, even if they’re based on international stock markets, so they can give you foreign exposure without using up the foreign-content room of your plan — also an attractive feature for RRSP and RRIF investors.

Sound like a no-lose proposition? Well, as with all investments, there’s a trade-off between risk and reward with stock-indexed GICs.

Next page: Things to look out for

Things to look out for

1. You may not get the full benefit of an increase in the index or the underlying stocks.

Unlike the growth potential from holding stocks, in return for safeguarding your principal, many issuers of index-linked GICs set an upper limit on how much you can earn. Depending on the issuer, the ceiling on returns could be tied to a number of variables: the performance of the related market benchmark, current interest rates and market conditions are common considerations. As well, these maximums generally do not take into account any dividends that would be paid if you held the underlying stocks directly.

Not only do they vary from issuer to issuer, the formulas used to calculate an investor’s actual return can be quite complex. One issuer, for example, bases its payouts on the average value of the index in the final four months of the investment’s last year; another uses the average of the month-end index closing value for the final 12 months of the investment. Make sure you understand how your potential maximum return is calculated.

2. If markets fall, you pay a cost in terms of lost opportunity

A guarantee of your principal investment, no matter which way the market moves, may seem unbeatable for an equity-related security, but think about what the real effect on your capital would be if the market did decline. Sure, you’d get your money back, but you also would have lost any potential gains from another investment such as the fixed rate on a conventional GIC. This foregone opportunity can add up to a substantial loss over five- or even three-year periods.

3. Your investment is not liquid

In contrast to holding stocks or mutual funds, which you can buy and sell at any time, a stock-indexed GIC must be held to maturity just like its conventional counterpart. Think twice about investing in one if there’s a chance you’ll need your money any time before the term is up.

4. Outside a registered plan, your returns will be taxed at the highest rate

Unlike the capital gains you get when your stock holdings appreciate, returns from a stock-indexed GIC are paid out as interest income, just like what you’d earn from a conventional GIC or other guaranteed deposit. This can make a significant difference to your after-tax income since interest income is taxed at the highest rate while just 50 per cent of capital gains — such as you would get from growth in your stock holdings — is subject to tax.

These common features aside, index-linked GICs can vary greatly in terms and conditions. If you decide to invest in one, be sure to understand the terms of your investment, including its term to maturity, the underlying index or indexes, as well as checking out whether there is a cap on your potential returns — and if there is, how the maximum is calculated.