Until recently, GICs or Guaranteed Investment Certificates, were mocked by many as “guaranteed poverty certificates.” But now, high interest rates are making GICs more popular in Canada. Why is that? And how do you know if GICs should have a place in your portfolio?
In this article, we explain the concept of guaranteed investment certificates, their advantages, disadvantages and uses.
What is a Guaranteed Investment Certificate (GIC)?
The guaranteed investment certificate is a bank investment product. Banks use GICs as a tool to finance themselves so that they can lend out funds. When customers of a financial institution borrow money to buy a house or when businesses borrow capital to finance their working capital, they take cash out of the bank. The bank must therefore offset this cash outflow with a cash inflow. Even for banks, money does not grow on trees!
To simplify things a bit, banks use depositors’ money to lend it to customers who are financing themselves. Also, just like money deposited in a bank account, GICs provide banks with cash that is available to be lent to borrowers. The bank generally makes a profit by paying less interest on the GICs than it charges borrowing customers. A GIC is simply an investment that pays you interest. With a few exceptions, GICs are not redeemable before maturity. In other words, your funds are frozen until they mature.
How do banks guarantee a GIC?
Since the bank is lending the money you invest in GICs to others, you may be concerned about the safety of your funds. Don’t worry. Guaranteed Investment Certificates, like bank deposits, are protected by the CDIC, the Canada Deposit Insurance Corporation. The CDIC is a Crown corporation whose objective is to ensure stability in the Canadian banking system. All chartered banks are members of the CDIC and therefore benefit from their protection. This is the guarantee of the GIC.
The Canada Deposit Insurance Corporation offers insurance that covers bank deposits, guaranteed investment certificates and savings accounts up to $100,000. Beyond this level, the guarantee no longer applies in the event of a banking institution’s default.
If you invest, say, $1 million in GICs with your bank, a portion of your investment will not be protected by CDIC. In other words, even if the word “guaranteed” is written in the prospectus and in the name of the investment product, this is far from being the case for large amounts.
If your financial institution were to go bankrupt, and you have concentrated $1 million in GICs, you are at risk of losing a large portion of it. I agree – that the risk is low! But in the midst of the commercial paper crisis in 2008, some financial analysts believed the event was increasingly likely. Just look at the fall in bank share prices at that time. When you consider that the bank is highly leveraged, it puts the risk into perspective. It is small, but it is real.
It should be noted that there are several techniques for multiplying CDIC coverage by using multiple bank charters within the same bank or by investing in different banks. Moreover, each legal entity is entitled to its own coverage. You can have an RRSP, a TFSA and a taxable investment, and still have $100,000 in protection for each account in several financial institutions.
Which banks are protected by the CDIC?
The six major Canadian banks are protected by the CDIC. Schedule 2 and Schedule 3 banks, which are smaller banks or Canadian subsidiaries of international banks, are also covered. At the risk of repetition, it is very important to note that amounts in excess of the $100,000 maximum coverage per corporate entity lose the CDIC coverage.
GICs or government bonds?
If we compare GICs to government and municipal bonds, which are also recognized as having very low credit risk, there are three major differences.
- Government bonds can be sold in the secondary market prior to maturity, unlike the GIC.
- Since they can be traded, bonds must have a price that fluctuates to interact with interest rate changes.
- There is no limit on the amount of collateral that can be pledged, as the borrower’s credit rating is the security, not an insurance policy like the CDIC’s. In the event of a problem, governments can raise taxes to pay off their debt or have access to many other tactics to access liquidity.
In the case of bonds or debentures, the interplay of interest rates creates price fluctuations that are normally small but can be significant if you have securities with very long maturities. For example, a Canada bond with a 2% coupon will be much less attractive than another Canadian government security with a 5% coupon. The price will therefore be the element that will tie up their performance at maturity. In bonds, even if two securities have different coupons, their yields to maturity should be similar if they have the same characteristics. In other words, by investing in a government bond or debenture, the return is only guaranteed at maturity. If you have to trade the security in the meantime, the return you receive may be different. In the case of guaranteed investment certificates, since they are not negotiable or tradable, their price does not need to fluctuate, they are always posted at their original price and they are only redeemable at the end of the term.
Risks and opportunity costs of GICs
investment because it is always at the same level. On the other hand, the GIC is not inherently risk-free. If you bought a GIC at 0.5% last year, your risk today is the lack of opportunity to reinvest at significantly higher rates until it matures.
Can GICs be an attractive investment? In economics, supply and demand dictate. In the years when central banks voluntarily crushed rates close to zero, banks could access funds almost free of charge from central bankers (the Bank of Canada) and therefore saw no need to turn to savers to access capital. They therefore had no interest in offering an attractive rate on GICs, hence the bad press. Today, on the other hand, regulators have restricted the money tap. So banks need to attract some capital from savers. This is being done by offering more attractive rates.
While investing 100% of your savings in a GIC to fund your retirement may be a recipe for failure, don’t dismiss the GIC at first glance. GICs, like common shares, preferred shares, government or corporate bonds, are an investment tool. It may be the solution to consider if you have a specific disbursement with a specific date in the short to medium term. For example, putting a down payment on a house in 36 months. It can also be part of the risk-free portion of your portfolio if it’s worth it. If banks are offering 5% while government bonds are at 4%, you can decide to invest a portion of your portfolio in them. We can build strategies similar to those used in bonds. For example, we can use a maturity ladder or target specific maturities to try to take advantage of the interest rate market.
Depending on market conditions and supply and demand, municipal bonds or other low-risk securities may offer a better return to investors and vice versa. Knowing that these securities can be substituted, the astute investor will evaluate the yield to maturity offered by the different assets to choose the one that offers the best rate.
In summary, GICs have received some bad press in the past, but this tool can still be of interest depending on your financial needs.