Market-Linked GICs – Genius, or Only Beneficial For Banks?

Market-linked GICs (Guaranteed Investment Certificates) are an innovative investment option for Canadians looking to capitalize on the higher return potential of stock markets while giving them peace of mind that their principal is still guaranteed.

These unique financial instruments blend the features of traditional GICs with the possibility of higher returns, depending on market performance. 

As such, they have become an attractive choice for investors who want a safe yet potentially lucrative investment. Are they the best GICs in Canada right now, or are they simply not worth it? Read on to find out.

What are Market-Linked GICs?

Market-Linked GICs, also known as Equity-Linked GICs, are a type of guaranteed investment certificate (GIC) that combines the safety of a normal GIC with the potential for higher returns based on the performance of a specified market or sector.

The interest earned on Market-Linked GICs is not fixed, as it is with a regular GIC. Instead, the interest rate is tied to the performance of an underlying market index, such as the S&P 500 or a specific market sector, during the term of the investment. 

This can result in higher potential returns if the linked market performs well; however, if the market performs poorly, investors may not receive any interest at all. The interest earned depends on how well the chosen index performs during the investment period. 

However, if the index performs poorly, the investor will still benefit from the principal protection, ensuring no monetary losses. Whereas had they invested in the market, they’d be down money.

With principal protection and potential for growth, market-linked GICs offer a unique opportunity for investors seeking diversity in their portfolios. They can be held in almost all accounts, including registered accounts like the TFSA, RRSP, RRIF, LIRA, FHSA, or RESP.

Who are market-linked GICs good for?

Due to their secured nature and potential for higher-than-average returns, market-linked GICs have emerged as a popular choice amongst conservative investors, but those who are willing to take on a bit of risk in regards to their returns. 

While they do not provide the same extent of growth opportunity as a direct investment in the equity market, they serve as a risk mitigation strategy for individuals looking to invest in the market without endangering their principal amount. 

Market-linked GICs have thus positioned themselves as a viable hybrid investment alternative for those in a particular financial situation.

The key differences between normal and market-linked GICs

A Guaranteed Investment Certificate (GIC) and a Market-Linked GIC are investment options that provide a guaranteed return on your principal at the end of a specified term. 

However, there are significant differences in terms of interest rates, return potential, and risk associated with these investment choices.

A regular GIC offers a fixed interest rate for the entire term, which may range from a few months to several years. The interest rate is determined at the outset and does not fluctuate during the term unless you choose a variable rate GIC.

On the other hand, a Market-Linked GIC has a variable return tied to the performance of a specified index or asset class, such as the stock market. 

As a result, the interest earned on an investment in a Market-Linked GIC depends on market fluctuations. However, the principal amount is still guaranteed, making it a relatively risk-free option.

Investing in a Market-Linked GIC can potentially lead to higher returns compared to regular GICs, but it may also result in lower returns if the market does not perform well. 

This makes it a suitable choice for investors seeking a potentially higher return than regular GICs without taking on much higher risk. 

When choosing between a GIC and a Market-Linked GIC, it is essential to consider the investor’s risk tolerance, financial goals, and investment horizon.

Those looking for predictable returns and minimal risk may prefer normal GICs, while more adventurous investors seeking greater potential returns tied to the stock market might be drawn to Market-Linked GICs. 

Ultimately, the choice depends on an individual’s preferences and requirements.

The main benefits of a market-linked GIC

Potential for higher returns

Market-linked GICs offer the potential for higher returns when compared to traditional GICs.

A traditional GIC will pay you regular interest regardless of where the stock market goes. A market-linked GIC, on the other hand, could end up paying you much more if the market goes up.

There are a few caveats to this, however. All of which we’ll talk about in the drawbacks of these GICs.

Market exposure without market risk

The performance of a market-linked GIC in terms of overall returns is dependent on the asset it is “linked” to. However, the principal is still guaranteed even if the linked asset were to crash in price.

This allows one to gain exposure to the positive movements in the stock market while avoiding the negative movements.

Security of principal

When investing in market-linked GICs, one key benefit is the principal’s security. Your initial investment amount is guaranteed regardless of how far down the linked asset goes in price.

The main drawbacks of a Market-Linked GIC

There is no guaranteed rate of return

A traditional GIC is going to pay you your fixed rate of interest regardless of whether or not the stock market goes up or down. A market-linked GIC, on the other hand, will only benefit you if the linked asset goes up in price.

If the asset goes down, you will simply receive your principal back, meaning you loaned the bank your money, and they owe you nothing in return for it besides your original amount.

Low liquidity relative to the stock market

These GICs are not as liquid as an investment in the stock market. Much like a non-redeemable GIC, you will not be able to touch your original principal until maturity unless you can provide significant financial hardship.

Meanwhile, with a stock, ETF, or mutual fund, you can at least sell your investment at the click of a button and have available cash at your disposal.

You are often capped in terms of potential performance

This is probably the biggest downfall of these types of GICs. Often, the banks will put performance caps or a participation factor on your GIC so that they ultimately benefit from selling you the product.

Your bank may say that the maximum return you can earn from your GIC is 10%. Meaning if the stock market rises by 30% over the term of your GIC, the bank will keep 20% of it and pay you 10%.

Alternatively, they may put a participation rate on your returns. It could be 50%, 70%, 90%, etc. What this means is that if you have a GIC with a participation rate of 70%, if the market goes up by 10%, the bank would give you 7% and keep the remaining 3%.

It’s not all that surprising these banks charge these types of fees. After all, they do have to make money. However, these capped returns are what really turn me off of market-linked GICs overall.

Your downside is protected, yes. But so is your upside as well.

Traditional GICs versus Market-Linked

Traditional GICs offer fixed interest rates, which guarantee a certain return for investors on their initial investment at the end of the term. 

In contrast, Market-Linked GICs offer a return based on the performance of a specific asset, such as a particular stock market index. 

While both types of GICs protect the principal investment, Market-Linked GICs provide the potential for higher returns if the index performs well but has a lower guaranteed minimum return.

In Traditional GICs, the interest rate is fixed and predetermined, providing stability and predictability to investors. This is suitable for conservative investors seeking a low-risk investment option. 

On the other hand, Market-Linked GICs offer exposure to the stock market, allowing investors to potentially benefit from positive market performance without the risk.

Are Market-Linked GICs a good investment?

For some investors, market-linked GICs can be a suitable choice for achieving specific investment goals. They offer a balance of safety and potential for growth with their guaranteed principal return and the opportunity to benefit from the performance of certain stock markets or sectors. 

However, I do believe specialized products like this often benefit the banks much more than the purchasers. The potential returns are usually capped, meaning investors won’t experience the same level of gains as directly investing in a basket of stocks.

However, I do understand that an individual investor’s risk tolerance and financial objectives can be specific enough that these products make sense.

How are mutual funds, stocks, or ETFs different From Market-Linked GICs?

Mutual funds, stocks, ETFs and market-linked GICs are distinct investment vehicles designed to serve different purposes within an investor’s portfolio. Mutual funds pool money from investors to buy a diverse range of stocks, bonds, or other securities, aiming to generate capital gains or dividends. 

Stocks are investments in individual companies, while Exchange-Traded Funds (ETFs) can provide broad exposure to a multitude of investment vehicles, even GICs via money market funds!

All 3 of these options expose someone to downside potential because their principal is not protected.

Market-linked GICs, however, guarantee repayment of the principal while providing a return tied to the performance of whatever asset it is tied to.

The main differences between these investment options are:

1. Guaranteed Principal: Market-linked GICs guarantee repayment of the initial investment, while all of the other options do not offer this guarantee.
2. Returns: Stocks, ETFs, or mutual funds can potentially offer higher returns over time compared to market-linked GICs, as they are not subject to a capped return. However, returns can also be negative, depending on market performance.
3. Risk: Market-linked GICs are considered lower-risk investments due to their guaranteed principal, while other investment options carry a higher level of risk depending on the type of securities held.

Things to consider if you’re going to buy a market-linked GIC

When considering market-linked GICs, it’s crucial to understand that there isn’t a one-size-fits-all product. The best market-linked GIC for an investor depends on their individual goals, risk tolerance, and investment horizon. 

Investors can choose from various Market-linked GICs across multiple strategies with a variety of payout structures. While a non-redeemable or cashable GIC is very simple in nature, Equity-Linked GICs are complex and have a significantly larger product base for investors to sift through.

Pick the term that works for you

The investment term is the length of time an investor’s funds will be locked in a market-linked GIC. Typical terms range from 1 to 5 years, with longer terms offering potentially higher returns. 

Investors should consider their cash flow needs and financial goals when selecting the term. However, one can utilize a GIC laddering strategy to add a bit more liquidity to your GIC portfolio. 

It’s essential to note that GICs held within registered accounts, like RRSPs and TFSAs, may have certain restrictions.

Interest rate environment

Market-linked GICs are influenced by the prevailing interest rate environment. The potential return on these GICs is tied to the performance of the underlying asset, which could be influenced by interest rates. 

When interest rates are low, traditional GICs may offer limited returns, making market-linked GICs more attractive. 

Conversely, when interest rates are high, traditional GICs may offer more competitive returns compared to market-linked GICs. Investors should take note of the interest rate environment and make informed decisions to maximize their returns.

Find the right bank and negotiate rates

In Canada, various financial institutions offer market-linked GICs. Some popular banks include RBC, TD, CIBC, and BMO. When selecting a bank, investors should consider:

• Whether or not the institution is a member of the CDIC
• The range of market-linked GIC products offered.
• The potential returns, fees, and costs associated with the GIC.
• Customer service and accessibility.

You have a lot of power as an individual investor. For this reason, you should be negotiating your rates with major institutions. You’d be surprised at how flexible they can be when it comes to giving you a bit more return on your money if asked.