The Costs and Risk of Guaranteed Investments

As most investors will know, we experienced a brief correction in the fall of 2018 which left a number of investors worried about what the future has in store for them. Because of this, it shouldn't be a surprise that there has been a renewed interest from some investors in guaranteed investments like GICs.  These are commonly offered by banks, credit unions, and other financial institutions and are often marketed aggressively.  With the renewed interest I thought it would be good to look under the hood of a GIC and see if it can be a worthwhile investment.

What is a GIC?

The main feature of the GIC is of course the fact that it is guaranteed.  If you hold the GIC to maturity, you will receive your principal and the contractual interest rate (provided the financial institution doesn't go bankrupt, which I'll talk about in a bit).  If I look at GIC rates today I see that the rates are averaging around 2.5% though you can get a rate around 3% for 5 year GICs from some local credit unions and other specialty finance companies.  If you were to buy one of these 5 year GICs you would be locking your money in for 5 years, and in return the GIC seller will provide you with 3% guaranteed annually.

The fact that it is guaranteed makes it very appealing to risk averse investors who don't want to worry about what the stock market is doing, or whether a particular company they own is making money or losing money.  Those investors want to have the feeling of security that they don't get from a stock. Unfortunately for those GIC investors, security comes at a price which is not well understood. The cost is the opportunity cost of locking up your money. If you want to understand the opportunity cost of a GIC you need to understand the motivations of the businesses that sell them.  No company is going to sell GICs if they don't have a way to make money.

How Does Money Get Made from GIC's?

So how do the banks, credit unions, and finance companies make money off your GIC if they're paying you a guaranteed interest rate?  They make money by taking your money which they've borrowed essentially and they re-lend that money out at a higher interest rate. I think the easiest way to understand this process is through an example.  

Let's say I'm a customer of TD Bank and I'd like to invest $200,000 for 5 years.  If I choose to buy a TD Bank GIC to invest, I will receive 2.2% annually for 5 years, and in 5 years time I will get my principle back.  I will get annual payments of $4,400 annually and on the 5 year anniversary date I will receive the last interest payment and my $200,000 principle back.  For that entire 5 year period though, my $200,000 is effectively TD Bank's money to do with as they please.  What they will likely do is lend out that money at higher rates of interest on things like mortgages, business loans, lines of credits, and others.  If they can lend your money out at a higher rate, they effectively profit off of the use of YOUR money with little risk to them.

It's also important to note that the rate offered by an institution is an inverse relationship with the amount of risk in the company itself.  What this means is that the riskiest companies need to offer higher rates to entice people to buy their GICs.  Those investors who invest in smaller or less creditworthy companies GICs will find that the guarantee isn't worth very much if the company who made it can't pay their bills.  Investors in Home Capital had this unhappy fact shoved in their face in 2017 when that company experienced financial hardship.  That is why Home Capital and its affiliated companies now offer GIC rates which are substantially above most of their bank and credit union competitors. It's because they have to, in order to get your business.  

Because TD is a much stronger brand and company then Home Capital, they get to pay less for their GICs as they have an ample supply of people buying them at lower rates. (As an aside, defaults by GIC issuers are not impossible and need to be considered by an investor, especially if you are investing more than the $100,000 covered by CDIC insurance.  Even if you are below the $100,000, you do not want to have to go through the hassle and uncertainty of making a CDIC claim.  Best to just focus on higher quality GIC issuers.  If you're not sure, you should contact your advisor to find out which ones are safe).

Some Other Important Considerations With a GIC.  

Your real return on your investment is the rate of return MINUS the inflation rate.  So if inflation averages higher than 2.2% over the next 5 years, we will actually be losing money on our guaranteed investment.  That's because we will be able to buy less in 5 years time then we could today.  The Bank of Canada's target rate of inflation is 2% so if they hit their target, our real rate of return is actually only 0.2% a year.  Inflation has been lower in recent years, but even at the current inflation rate of 1.5% we are looking at a real return of 0.7% a year.  

No one knows what inflation is going to look like in the future, but it is a big risk when talking about GIC returns and is one of the main disadvantages of a GIC. For non-registered or corporate accounts (non RRSP, Pension, or TFSA accounts) it gets even worse because GIC interest is fully taxed as income.  This means that you won't get the lower tax rates that dividends and capital gains receive.  If we assume you're paying the top marginal tax rate in MB of 50.4% (Other provinces would be similar) that means that the $4400 of interest I receive is actually $2182.40 after tax.  If we factor in tax and inflation our real return actually becomes -0.41%.  That's right, you will be guaranteed to lose money after inflation every year for the next 5 years. For me, these numbers aren't very appealing.  

What can we do instead with our investments?

Well, if you really are deathly afraid of losing your principle, then there are some options which can still help you, which don't require you to accept a negative real rate of return.  These options include, principle protected notes, index linked GICs, or segregated funds. These are contractual investments which can be somewhat complicated but can deliver the possibility of higher returns while still guaranteeing part or all of your principle.  If these sound interesting I would highly recommend you speak to an advisor to get a recommendation as they are very complex investments.

For myself, my solution is a bit simpler.  Instead of buying the TD Bank GIC at 2.2% a year, I'd much rather buy TD Bank stock. If I buy $200,000 worth of TD stock, I will be paid $2.68 a share or 3.63% in dividends every year.  For $200,000 this would equal approximately $7260 a year which is substantially more than the $4400 I would get for the GIC. That dividend isn't guaranteed but TD has consistently paid their dividend for over 100 years.  

What's more, the dividend isn't frozen and TD has increased their dividend in each of the last 5 years.  So it's very likely that my payments will go up over time. TD's payout ratio (a measure used to assess how safe their dividends are) is only 44%, which suggests that TD is not in danger of having to cut their dividend.  Even if there was a major financial collapse where TD's dividend was threatened, I would argue the GIC investor would be facing the same identical risk.  If TD can't pay their dividends, it's unlikely their GIC payments are going to be very safe either.  The dividends we receive are also more efficient tax wise as instead of paying 50.4% tax in Manitoba you would only pay 37.78% on the dividends.  So you get a much higher payment which is taxed at a much lower rate.  

Owning TD Bank stock will also be much more resilient to inflation pressures than a GIC would, so in a high inflationary environment, we would do much better with our TD Bank stock then we would with a GIC. The main risk of this strategy is of course that TD's stock could be trading for much less than what I paid in 5 years time.  This is a valid concern, and if you need to ensure the principle is safe, you shouldn't use my strategy.  However if it's only income you're looking for, you don't really care what the share price trades at, as long as you can continue to collect your dividends.

What's more, the stock is actually much more likely to be higher in 5 years time based on the quality of the TD business and the historical track record.  If your investment horizon is longer than 5 years, the appeal of the TD Bank stock only gets better.  Over 10 years or longer, I would assign a very high probability that the TD Bank stock will be worth more in 10 years time than it is today.  And of course you would be collecting your dividends all the while.

Associating 'Guarantee' with 'Risk-Free' is a Mistake

I think the biggest mistake investors make is that they associate the word guaranteed with risk-free.  There is no investment that is risk free.  When you buy a GIC, you aren't eliminating risk, you are simply substituting one risk for another.  Depending on your financial plan and personal situation, that may be ok, or it might not be ok.  But if you don't understand the risks, or if you think there aren't any risks at all, you are setting yourself up for trouble.

- Craig White, BA, LL.B., CIM

Craig White is an Investment Advisor at Endeavour Wealth Management with Industrial Alliance Securities Inc. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.

This information has been prepared by Craig White who is an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.