The Pros and Cons of Foreign Currency GICs

GICs come in all shapes and sizes: Long- and short-term, cashable and non-redeemable, and even equity-linked GICs.

Investors may also consider purchasing foreign-currency GICs. We’ll look at what these products are, their pros and cons, and what influences the value of the Canadian dollar versus its American counterpart (virtually all foreign currency GICs in Canada are linked to the U.S. dollar).

What are foreign currency GICs?

When you buy a regular GIC, it’s denominated in Canadian dollars. In other words, you buy it using Canadian currency, and at the end of the term, Canadian dollars are returned to you, plus interest.

Foreign currency GICs work slightly differently. When you purchase one of these GICs, your investment is denominated in the currency of the product. You either can use foreign currency you already have on hand to make the purchase, or the bank selling the GIC will do a currency exchange to facilitate the transaction. For example, you’ll buy a U.S. dollar GIC with Canadian dollars, and the bank does the foreign exchange in the process. This latter part can cost a bit of money because the bank will sell you the U.S. dollars at a slight markup to the foreign exchange rate.

At the end of your term, you’ll get back the principal plus interest in the foreign currency. Between the time of your purchase and the end of the term, the Canadian dollar will have fluctuated against the foreign currency. In theory, the exchange rate could be the same value, but currencies move up and down so odds are it won’t stay the same.

Advantages

The major advantage of a foreign currency GIC is the potential for cushioning yourself against declines in the Canadian dollar. Let’s say you buy a U.S. dollar GIC when the exchange rate is $0.78 ($0.78 of a U.S. dollar buys one Canadian dollar). A year later, when the GIC matures, maybe the dollar has fallen 10%. You’ll make money because the U.S. dollar will buy more Canadian dollars. This can be useful in a few ways:

• It provides you with a capital gain, just like if you bought and sold a stock for a profit
• If you travel to the U.S., you won’t suffer from a weaker Canadian dollar when you make purchases with your U.S. dollars
• Similarly, if you buy goods in Canada that are imported, and their price has risen because of a slumping dollar, you’ll insulate yourself somewhat

Disadvantages

It’s not all sunshine and roses, however. There are some drawbacks to be aware of if you’re thinking of buying a foreign currency GIC:

• You could lose money. This can happen if the Canadian dollar rises in value against the foreign currency in question. In this case, when your GIC matures, your Canadian dollar buying power will have declined.
• Interest is very minimal. Canadian dollar GIC rates are much higher than foreign currency GICs.
• They’re not insured by the Canada Deposit Insurance Corporation (CDIC). This is important. Should your bank fail, the government’s deposit insurance plan won’t cover these products.

What causes the Canadian dollar to fluctuate?

Before buying a U.S. dollar GIC (the vast majority of foreign currency GICs), you should know why the Canadian dollar goes up and down against the American currency. Truth be told, there are many factors, especially on a day-to-day basis. Here are the key ones:

• Trends in commodity prices: Canada produces and exports a large amount of natural resources (metals, oil, grains). As commodity prices increase, our dollar tends to rise in tandem and vice versa. Oil is generally thought of as the key driver in this respect.
• The level of Canadian interest rates relative to U.S. rates: Investors tend to gravitate towards currencies with better interest rates, all things being equal. If the U.S. Federal Reserve raises interest rates and the Bank of Canada leaves rates unchanged or lowers them, the U.S. dollar will typically rise against the Canadian dollar. Expectations for future rates are particularly important in this regard.
• Trends in the U.S. dollar and economy: The exchange rate can fluctuate based on economic factors in the U.S. Research by the Bank of Canada has identified the debt-to-GDP ratio south of the border as an important variable affecting the exchange rate.

Even if you do want exposure to the U.S. dollar, don`t put all your eggs in that basket. As mentioned, foreign currency GICs aren’t CDIC-insured. That, plus the potential for capital loss means that like everything else in investing, it`s wise to not be overly concentrated in one currency. For those who are interested in a foreign currency GIC, make sure to look at the best GIC rates before making a purchase.