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Understanding GICs

It used to be that Guaranteed Investment Certificates (GICs) and term deposits were the products of choice for conservative investors. But a steady diet of declining interest rates during the past decade saw investors move to higher risk but better paying investments, such as mutual funds.

That was until the markets crashed and investors sought safer investments, even though their pitiful interest rates barely covered inflation.

Now, with interest rates expected to bounce off 40-year lows and a range of more flexible products hitting the shelf, the lustre is returning to GICs and term deposits, though rates are still painfully low. At least for now.

"Investors are starting to show some interest again because of the upswing (in interest rates)," says Joan Dal Bianco, vice president of term investments for TD Canada Trust in Toronto.

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According to the Superintendent of Financial Institutions, Canadians had $277.2 billion in fixed-term deposits (including GICs) in March 2004. That's down from the same time last year, when Canadians had $282.5 billion in fixed-term deposits.

The flight to safety peaked in 2002, when Canadians socked away $283.5 billion in fixed-term deposits, $52.4 billion more than they had at the height of the Internet stock market bubble in 1999.

A GIC is a safe, conservative investment issued by a bank or a trust company and is normally insured by the Canada Deposit Insurance Corporation. It is insured for as much as $60,000 at member institutions.

According to Dal Bianco, the main difference between a GIC and a term deposit is liquidity, or how easy it is to cash out of the product. Generally, a GIC is not cashable before maturity, while a term deposit can be redeemed early. But that distinction is falling by the wayside as financial institutions develop more sophisticated GIC products.

Julie Sheen, vice president of term investments at Bank of Montreal in Toronto, says fixed-term investments generally fall into three categories: traditional, flexible and index-linked.

Traditional GICs
Original GICs had a fixed term and a fixed rate, says Sheen. They were non-cashable and came in one-, three- and five-year terms. Today, you can buy them with a range of terms.

Generally, a minimum deposit of $1,000 is required, although some go as low as $500. The more you invest, the higher the interest rate you receive. You can hold GICs inside or outside of your Registered Retirement Savings Plan (RRSP) or Registered Retirement Income Fund (RRIF).

In addition to Canadian GICs, some institutions offer foreign currency term deposits, including U.S. dollar GICs. The interest a GIC earns is paid at various intervals, including monthly, semi-annually or at maturity.

Flexible GICs
Diane Lyons, vice president of personal financial services at HSBC Bank Canada in Vancouver, says the traditional GIC had a "flexibility issue." Once an investor locked in, he couldn't access his money until maturity, which was damaging to his overall return in a rising-interest-rate environment.

"You need to be able to say, 'I want my money back, I changed my mind,'" says Lyons. So the banks developed flexible GICs that are cashable. They pay lower interest rates than locked-in GICs but allow investors access to their money at a range of times, including as few as 90 days, without penalty.

TD's Dal Bianco notes that "in this current low-rate environment, customers have been tending to invest for the short term," and flexible products allow them to do that. "The challenge in this low-rate environment is that there's always the hope for rates to turn around."

To accommodate concern about rising rates, banks have created GICs whose interest rates escalate over time. For example, TD has the Five-Year Stepper GIC, which allows investors to withdraw funds before maturity, but the interest rate increases each year of the term.

Index-linked GICs
The third category is the index-linked GIC. It is designed to give investors more bang for their buck by tying its performance to a stock index or mutual fund.

Dal Bianco says they're for "customers who still have some reservations about participating in the equity markets." It exposes them to the upside potential of a rising market while limiting their downside risk by guaranteeing their principal.

But don't expect to get the full benefits of a rising market. Index-linked GICs limit potential gains one of two ways.

The first is with a cap. The GIC allows you to participate in 100 percent of the gain over the life of the investment, but it's capped at a pre-determined percentage, such as 20 or 30 percent.

The second is a market participation rate -- as high as 65 percent for some GICs -- that allows you a percentage of the gain over the life of the investment. Sheen says the "biggest difference is that the participation rate doesn't limit your upside" in the way that the cap does.

GICs can be linked to Canadian, U.S. or foreign markets and, like a regular GIC, can be held inside or outside an RRSP and require a minimum contribution, as low as $500. However, you normally have to commit the money for a minimum of three to five years. And the longer you invest your money, the higher the cap or participation rate.

The returns can be substantial. For example, Scotiabank has a three-year GIC linked to the S&P/TSX 60, which caps returns at 20 percent. Over the years, it has paid out anywhere from zero to 20 percent. If you held one to maturity during the market's rise in 2000 and 2001, you earned a handsome return of 20 percent. If you held one to maturity during most of 2002 and 2003, however, you wouldn't have earned anything on your investment.

Compare the capped GIC to a participation rate GIC, such as CIBC's Market Mix GIC. It's a five-year investment linked to the Canadian, Japanese, European and U.S. markets and features a market participation rate of 65 percent. It produced an annual compounded return of 9.11 percent between 1997 and 2001, or an overall return of 54.71 percent. See Bankrate's GICs/Savings home page for current GIC rates.

Don't forget about taxes
While returns like that are nice, investors must consider the tax ramifications. Lyons says investment return from GICs is treated as income, even if it's an index-linked GIC, so that means the money earned will be taxed unfavorably compared to dividend income or capital gains, and you could wind up paying much of your return to the tax man. That's the trade off, she says, for having your principal guaranteed.

While GICs have come a long way from the basic term deposit, there are still opportunities on the horizon for new products. Sheen says that in the future, GICs will go beyond equity indexes and into other types of investments, such as gold and energy futures.

Lyons adds it's important for investors to shop around and consider their options. The best way to do that is visit the Web sites or each bank and check their products. While the traditional GICs are the same, it's in the flexible and index-linked categories that they differ the most.

Jim Middlemiss is a freelance writer and lawyer based in Toronto. He's a frequent contributor to the National Post, Investment Executive and Wall Street & Technology.

-- Posted: June 18, 2004
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