Index-linked GICs sound too good to be true — and they are

When you join my Inner Circle service, you get to ask me your own personal investment questions, plus you get to see what other Inner Circle members have asked, along with our answers.

So you can see how the service works, and get a sense of how you could benefit from it, I’d like to share a recent member question about index-linked GICs. I hope you enjoy and profit from it.

Q: Hi Patrick. I am interested in your opinion of index-linked GICs. The returns are interest based, so I think they are best bought in your RRSP. Recent stock market volatility has us wanting to safeguard a portion of our portfolio. Thanks.

A: Index-linked guaranteed investment certificates (GICs) are just one of a variety of investment products that propose to provide the holder with guaranteed income plus capital gains linked to growth in one or more stock-market indexes, commodities or whatever.

Index-linked GICs are marketed as offering all of the advantages of stock-market investing with none of the risk. But banks and insurance companies aren’t in the business of giving customers something for nothing. The capital gain that holders get depends on an ingenious formula, spelled out in the fine print, which is cleverly designed to sound generous while minimizing the potential payout.

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Another drawback is that returns on index-linked GICs, or bonds linked to an index, are taxed as interest. That’s because you’re not actually investing in the stock indexes themselves; you’re just getting paid interest based on the change in the indexes. That’s a drawback because interest is the highest taxed of all investment returns. Usually, stock-market investing yields capital gains and dividend income, both of which are taxed at a lower rate than interest. Of course, if you hold the GICs in an RRSP, all income is tax deferred.

These GICs do protect your principal, and you make a modest gain after several years. However, your gain will likely be a costly way of offsetting the risk you avoided by staying out of mutual funds, not to mention your sacrifice in yield and tax advantages. You’re better off to confine yourself to so-called “plain vanilla” stocks and bonds, or funds that invest in them.

If you already own index-linked GICs, our advice is to cash them in at the earliest opportunity. If you don’t own them, we recommend that you stay out.

If you have investment-related questions like these, or if you’d like to ask me about stocks you’re considering buying (or selling), you should join my Inner Circle service. Click here to learn more.