With equities mar-kets gripped by volatility and threatening to turn bearish, market-linked guaranteed investment certificates could be the right investment for the cautious client who’s looking for safety while still exposing him- or herself to the possibility of generating higher returns.

“This is a great product for customers who are nervous either to go out and buy stocks on their own or to purchase mutual funds, because you have the principal-protected feature,” says Sarah Armstrong, associate vice president of term investments with TD Canada Trust, the banking arm of Toronto-based TD Bank Financial Group.

A market-linked GIC is a guaranteed investment vehicle whose performance is linked to an underlying index, a basket of equities or an investment fund. The principal amount is guaranteed; the client participates in any gains made on the underlying security at the time of maturity, limited either by a maximum cap or by a participation rate.

Market-linked GICs are offered most often with three- or five-year terms and are insured by the Canada Deposit Insurance Corp. They are usually non-redeemable until maturity.

“Market-linked GICs have been popular,” says Scot Bashford, director of product management and development for BMO term investments at Bank of Montreal. “We’ve seen them as a diversification tool [for clients]. We have a number of equity-linked GICs in the marketplace and they really are wide and varied.”

BMO offers a dozen market-linked GICs, some of which are based on indices such as the S&P/TSX 60 or the S&P 500 composite index, while others are based on a basket of underlying equities. BMO Dividend Fund Linked GIC, for example, is based on one of BMO’s largest and most popular mutual funds.

PERFORMANCE HEALTHY
The investment performance of market-linked GICs has been healthy, and in some cases, excellent. Armstrong cites the example of TD’s Financials GIC Plus, which is linked to the S&P/TSX banks index. A five-year Financials GIC Plus bought on July 31, 2002, and maturing on July 31, 2007, she says, would have earned the capped maximum of 75% of the growth of the index in that period, which works out to an average annual return of 11.8%.

That gain would have been realized while the investor enjoyed a guaranteed return of principal, she adds.

This past year, TD introduced Security GIC Plus, which offers investors a guarantee on principal plus a minimum interest payment upon maturity. The five-year version of the GIC, which is tied to an equal weighting in the S&P/TSX banks index and the S&P/TSX capped utilities index, offers a minimum payment of 15% and a maximum of 40% of the principal at the time of maturity, depending on the performance of the underlying indices.

“The Security GIC Plus was very popular,” says Armstrong, “and told us that the No. 1 priorities for GIC customers were rate and security.”

TD has so far decided not to introduce market-linked GICs based on a hand-picked pool of equities because it feels that an index is easier for investors to follow. “That’s not to say we wouldn’t consider it in the future,” Armstrong says. “But it’s easier for a customer to understand an index, for which he or she can look up the return, rather than a custom basket of stocks that we’ve put together.”

Both issuers and industry experts say that market-linked GICs are best used as a part of a diversified portfolio, either as a way to give an otherwise risk-averse investor some exposure to the specific market or to give a more aggressive investor a hedge against an equity position.

“If you’re fully exposed to, say, Canadian equities and want to reduce the risk of a market downturn but still want to participate in potential growth, then certainly an index-linked GIC is a good complement,” says Robert Whipp, an advisor with Oakville, Ont.-based Fiscal Agents Ltd.

Timing is the key factor in determining whether purchasing a market-linked GIC turns out to be a successful investment, Whipp says: “The time to buy them is when an index has dropped. You know you’re in for a three-year or five-year ride on them, so, hopefully, you’re buying in at a trough, not a peak.”

The flip side of that is that during bull runs, buying a market-linked GIC will probably be a weaker investment than investing fully in the market. “If the market is doing well, why not go into a mutual fund rather than a linked product?” Whipp says. “Investors get full growth in mutual funds. Over the past three years, being in a mutual fund would have been better than an index-linked GIC.”

@page_break@Depending on the issuer, returns on market-linked GICs are either capped at a maximum level based on a percentage of the original investment or are subject to a participation rate, in which the investor and the issuer split any gains according to a pre-set ratio.

Issuers limit gains, Whipp says, in order “to compensate themselves for the risk in management” of these products.

BEST HELD IN RRSPS

Whipp says that market-linked GICs are best held in an RRSP, as opposed to a non-registered account, as income from an equity-linked GIC is fully taxable, usually in the year the investment matures. “If the income all comes in the fifth year [of a five-year investment],” he says, “there could be a substantial tax bite on that.”

Armstrong agrees that market-linked GICs are ideal for RRSPs and have been very popular leading up to the RRSP deadline. “This is the biggest selling season for these products,” she says.

The most significant risk with market-linked GICs is that the underlying index falls in value over the period the GIC is held, leaving the client with nothing but his or her principal. If the index doesn’t rebound, the investor is stuck in the vehicle for the next few years, waiting to redeem it with no gain.

Market-linked GICs bear a lot of resemblance to principal-protected notes in how they are structured and function, but there are several key differences. PPNs tend to be structured in a more complex way and have fees attached to them. They are generally sold through investment advisors and often don’t have any caps, in terms of gains that can be realized. PPNs also can run longer than five years and some can be cashed in before maturity, although the principal guarantee is then waived. PPNs are not insured by CDIC.

Market-linked GICs don’t have fees attached and are kept to terms of five years or less in order to qualify for CDIC insurance. They are linked to conservative indices or baskets of equities.

Canada’s biggest banks are the primary providers of market-linked GICs, and most of these products are sold through bank branches.

There were $18.8 billion in market-linked GICs issued as of Sept. 30, 2007, up from $16.3 billion in Dec. 31, 2005, which represents a gain of 15.3% over 21 months, according to Investor Economics Inc. , a Toronto-based financial services research and consultancy firm.

Meanwhile, over the same period of time, the amount of assets in PPNs rose 84.3%, to $22.3 billion as of Sept. 30, 2007, from $12.1 billion as of Dec. 31, 2005.

The stronger growth in PPNs sales vs market-linked GICs comes down to the strength of the distribution channel for PPNs and the fact that market-linked GICs haven’t shown spectacular performance, says Carlos Cardone, a consultant with Investor Economics.

Nevertheless, the issuers of market-linked GICs “appear committed” to continuing to offer the investment vehicles. New products, the Investor Economics report says, will continue to be introduced.

“Market-linked GICs are more of a sold thing than a bought thing,” Whipp explains. “It’s very rare for someone to come in and ask for one. Most people aren’t familiar with them.”

Armstrong says that although market-linked GICs remain a niche product among TD’s wider stable of more traditional GICs, sales growth has been strong. In 2007, the market-linked GIC segment at TD enjoyed 46% growth in terms of assets.

“Some of the market-linked GICs have done quite well,” Whipp agrees. “An investor would have made a fair bit of money on them.”

The development of the market-linked GIC market mirrors a wider growth in all types of GICs, including cashable GICs, which offer easy redemption terms; escalator GICs, which offer higher rates every anniversary year; and income-generating GICs, which offer investors an income stream.

The wide variety of GIC choices can be bewildering for some clients, Whipp says: “Most GIC buyers are looking for a simple product that they don’t have to worry about.”

GICs buyers today tend to favour short-term and cashable GICs, as confusion over the direction of interest rates in the short and long terms is causing investors to seek safe harbours and avoid being locked in.

“GICs with flexibility and cashability are extremely popular, and they have been for a long time,” says BMO’s Bashford. “However, when you get into circumstances such as those in the current market, they become even more popular.” IE