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The Money Management Newsletter: GICs and Fixed Income
Do your homework before buying index linked GICs

Considering that 5 year GIC rates are hovering in the 5.5 per cent range and North American stock markets have gone through a substantial decline in the past year, is this a good time for the conservative investor to consider an index linked or stock linked GIC? It think the answer is a qualified "yes".

I say "qualified" because I feel this type of product is much better suited to RRSP investments over non registered investments. Outside of an RRSP, the tax treatment of the income is not very favourable as I will explain later in this article.

As far as now being a suitable time to buy, we can look at the current situation for two indices used by most institutions for their stock linked products; the S&P 500 (a broad U.S. market index), and the S&P/TSE 60 (an index comprised of 60 large Canadian stocks). We note that both of these indexes have fallen by over 30 per cent from their peaks achieved last year and while the S&P 500, at the time of writing (May 2, 2001), is 17 per cent below its high, the S&P/TSE 60 has had minimal recovery. Timing the market is always difficult but it is safe to say that there is less risk buying into one or both of these indexes now as opposed to this time last year when they were near their record highs.

For anyone considering the purchase of a stock linked GIC, do your homework and check out the product features from different institutions as they can vary substantially. Some companies simply base your return on the percentage gain of the index between the issue date and the maturity date of the GIC. Others will use the monthly average of the index over the term of the GIC or some other average int heir return calculations. The average return calculation is less risky in the event that the market collapses around your maturity date.

Don't think however, that you will receive the full gain of the index as in most cases the institutions will limit your return to a maximum percentage. Be sure to investigate what this will be as their maximum returns may change from time to time. One point of interest is that some companies will allow you to lock in your return at certain times prior to the maturity date of the GIC. If for instance, your maximum return is 30 per cent over three years and you have already reached that level by the end of the second year, you should lock it in if permitted as your return won't get any higher.

Stock linked GIC are in most cases tied to a certain index. National Bank however has recently introduced an actively managed product which allows the managers to create what they feel is the optimum portfolio of stocks. This presents a good complement to an index linked GIC as the manager can take a defensive position in a declining market. This particular product has no maximum return limit at the present time.

I indicated earlier that these types if GICs are not that well suited for non-registered investments and this is because of the way the income is taxed. If you invested $50,000 in a stock linked GIC for five years which had a maximum return of 60 per cent and you reached that maximum, you would have $30,000 of taxable income to report for the year of maturity. You cannot apply any of the income to earlier years and it is all treated as interest income and as such is fully taxable. Imagine how an additional amount like this would impact such things as old age security clawbacks, GST rebates and age credits.

It is also possible that your marginal tax rate may increase to the next level so that more of the GIC return goes to taxes than would be the case if it was spread out over the life of the investment. Compare such results with a lower earning regular GIC where you claim the interest income each year as it is earned.

CDIC coverage does apply for stock linked GICs, making them an attraction for conservative investors, however the unattractive tax treatments erase some of their allure.

Within a registered product such as an RRSP, this problem will not exist as none of the return is taxable. Only withdrawals from you RRSPs attract tax. Bear in mind though that the returns for stock linked GICs are not guaranteed so it is possible to receive only your original principal back at maturity with nothing in the way of return. These GICs cannot be redeemed before maturity (the only exception being if you die) so if the market starts to tumble prior to your maturity date, there is nothing you can do to preserve your earnings unless you were able to lock in your return at an earlier date.

If an investor can make allowances for the tax issue and the inflexibility of the product, a stock linked GIC purchase at this time can be a relatively low risk method of taking advantage of the stock market decline.

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