Are GICs Really a Safe Option?
With the increased market volatility that people have experienced this year, more and more investors are looking to the security of Guaranteed Interest Certificates (GICs) to protect their savings. However, what many people do not realize is that while most GICs are not subject to market risk, there are other types of risk that can affect a GIC.
To understand this, let’s look at what GICs are. GICs and Term Deposits are debt instruments issued by banks, trust companies or other financial institutions that guarantee investors a fixed rate of interest for a set term. The investment period for a term deposit/GIC can be measured in days, months or years. Depending upon the financial institution, these debt instruments can be purchased for short durations such as 30, 60 or 90 days. They may also be available for investment periods of 1 – 5 years and some institutions offer terms that extend well beyond the five years.
At the end of the investment term, the instrument matures and the financial institution returns the principal and any interest payments owing to the investor. The minimum amount of principal required for investment will differ by financial institution.
If a GIC is held outside of an RRSP, it is important to know that the income earned is treated as interest income. Also, an investor must report accrued interest annually even if the investment is for longer than one year and that investor won’t receive the funds for another 1 – 4 years.
So now that we understand what a GIC is, what are the risks? A GIC is subject to 3 types of risk, Inflation Risk, Reinvestment Risk and, to a much lesser extent, Default Risk.
Inflation risk is the probability that price increases will erode the value of an investment. A GIC provides a maximum or capped rate of return which means that it cannot adjust to increases in inflation. If the interest rate on a GIC is lower than the rate of inflation then, while your principal will remain the same, the purchasing power will continue to fall every year. For example; at the time this article was written the average 1 year GIC posted rate was 1.2%, the core CPI (rate of inflation) was 2.4%, therefore even if you are in the lowest marginal tax bracket of 24.2% your Real After Tax Rate Of Return on a GIC would be -1.49%.
Reinvestment risk refers to an investor’s ability to take future proceeds and reinvest them in securities that have similar risk/return profiles. It is the risk that, when the investment matures, if you purchased the same investment again it would be at a lower rate. There are mixed opinions on the risk this presents in the current market. Some people feel that interest rates are going to continue their downward trend while others feel they can’t go much lower and will start to climb. Whatever happens, it is a risk you should be aware of.
Default risk is the risk that a company will not have the funds available to pay the principal owing on an outstanding debt at maturity. This risk is very minimal for a GIC. Most financial institutions that offer GIC investments are members of CDIC or Assuris which means that, if you qualify, your investment is protected up to $100,000 in the event of the financial institution failing. If your total investments in like accounts exceed $100,000, the excess is not protected. Splitting your money into separate accounts does not increase your protection amount. Also, your deposits are not protected if your financial institution is not a member of CDIC or Assuris (i.e. credit unions, caisse populaires, Canadian branches of foreign banks, and some Canadian chartered banks). You may want to check to make sure your deposits are protected through CDIC, Assuris or other provincial deposit insurance programs to assess your exposure to Default risk. You can get more information on CDIC and Assuris at their websites. www.CDIC.ca and www.Assuris.ca.
A GIC is much less volatile than securities held in the market but that does not mean they are risk free and the low rate of return may make them inappropriate for some investors. If you would like to learn more about GICs and how they can fit into your portfolio please contact a professional at Langlois Financial Services Inc.