Investment Vehicles in Canada

*Note: The information provided in this article is for educational purposes only and does not constitute financial or investment advice. The complexities of these instruments require thorough understanding and should be approached with caution. Many specific details and nuances have been left out due to the broad nature of subject. Readers are very strongly advised to consult a qualified financial planner. Do not make any investment decisions based on information presented here.

Capital is all about wealth, whether it’s something you can touch like buildings and land or something a bit more abstract like cash and shares. It’s basically the extra savings that people, businesses, and even governments have, and there’s always a demand for it. When we talk about investment, we mean giving up something now to gain more value later. The main reasons for investing are to keep your capital’s value intact or even grow it. Just stashing cash doesn’t do that; in fact, it usually loses value over time because of inflation.

Not everyone has the same goals when it comes to investing. For instance, if someone has extra cash each month or a retiree gets a severance package and just leaves that money in the bank, they’ll likely find their money isn’t worth as much after a while. And high earners or business owners might worry about their financial future, especially if their company hits hard times.

Here’s a common myth: you don’t need a ton of cash to start investing. There’s no set amount to begin with; you can dive into investing with just about any amount. What really matters is not how much cash you have, but how you manage your time.

In Canada, the finance and investment markets are super important. They help move money from savers to those who need it, which drives economic growth, creates jobs, and boosts the country’s GDP.

If you’re looking to start investing, you’ll want to consider two things: your financial situation and your comfort with risk. Different investment options come with varying levels of potential growth and risk. Generally, lower-risk investments offer steadier but lower returns, while riskier ones can lead to higher rewards. But remember, risk works both ways. Risky investments can have great upside, but they also carry a higher chance of loss, especially in the short term.

In Canada, there is variety of investment options, each with its own potential for growth and associated risks.

Savings accounts are sometimes categorized among the simplest and most commonly used investment tools in the country. However, given their low returns, for the purpose of this article, we’ll consider them more as ‘savings vehicles’ than true investments. Beyond savings accounts, other investment options can be grouped into different categories as follows:

• Fixed-income Securities: These include bonds, debentures, mortgages, and more. When you invest in fixed-income securities, you’re essentially lending money to the issuer (e.g., a government or company) in exchange for periodic interest payments and the return of your principal at maturity. Unlike equity, you do not own part of the company.
• Equity Securities: Buying equity means owning a portion of a company and sharing in its profits or losses. Unlike bondholders, equity holders bear greater risk but also enjoy the potential for higher returns if the company thrives.
• Derivatives: These are financial instruments whose value is tied to an underlying asset like stocks or bonds. They are more complex and used for various strategies, including hedging or speculation.
• Managed Products: Examples include mutual funds, which are professionally managed portfolios of stocks, bonds, and other assets. Investors buy shares in the fund and benefit from its overall performance, but pay a management fee for professional oversight.
• Structured Products: These combine elements of different investment types, such as equities and bonds, often using financial engineering. Examples include principal-protected notes and index-linked GICs, offering diverse risk and return profiles.

Each investment type offers different risk-return trade-offs, and careful consideration of your financial goals is key.

Understanding Different Types of Investments

• Bonds: Bonds are like loans. When you buy a bond, you’re lending money to a government or company. In return, they promise to pay you regular interest and return your initial investment (the principal) at a set date, called the maturity date. The regular payments are called coupons. In the past, bonds had physical coupons attached to them, which investors could turn in for payment. Nowadays, bonds are digital.

Governments and companies issue bonds to fund projects or operations. While companies have other ways to raise money (like bank loans or issuing stock), governments rely heavily on bonds. Bonds are considered “fixed-income securities” because they provide steady, reliable income.

• Debentures: These are similar to bonds, but they aren’t backed by physical assets like buildings or land. Instead, debentures are supported by the issuer’s creditworthiness or reputation. For example, government bonds are technically debentures because the government doesn’t offer physical collateral. Instead, their reliability is backed by their ability to collect taxes and manage national finances.
• Treasury Bills (T-Bills): These are short-term government bonds, typically maturing in less than a year. Instead of paying regular interest, T-bills are sold at a discount and later redeemed at full value. The profit comes from the difference between the buying price and the face value. They’re often seen as a safer place to park cash for a short time.
• Canada Savings Bonds (CSBs) and Canada Premium Bonds (CPBs): These were popular government bonds, but they were discontinued in 2017 due to declining interest. However, those who still own them can cash them in when ready.
• Real Return Bonds: These bonds offer protection against inflation because their interest payments increase with inflation. They function like regular bonds but ensure your investment keeps up with rising prices.
• Provincial and Municipal Government Securities: These are like federal bonds but are issued by local or provincial governments. They usually offer higher interest rates because they are slightly riskier than federal bonds, reflecting the specific region’s financial health.
• Corporate Bonds: Companies can also issue bonds to raise capital. These tend to carry more risk than government bonds, so they usually offer higher interest rates. Corporate bonds come in many forms, including ones backed by physical assets (collateral trust bonds) or equipment (equipment trust certificates).
• Mortgage Bonds: These are bonds backed by mortgages on real estate. Banks often bundle several mortgages and sell them as bonds to mutual funds. This process frees up the bank’s balance sheet, allowing it to issue more loans.
• Floating-Rate Securities: These bonds have interest rates that change with inflation. If inflation rises, so does the interest on these bonds, making them attractive during times of rising prices.
• Domestic, Foreign, and Eurobonds: These are bonds issued outside Canada or in a different currency. Investors may choose foreign bonds if they believe their domestic currency will weaken, providing an opportunity to earn in a stronger currency.

Other Fixed-Income Securities:

• Bankers’ Acceptances (BAs): These are short-term, bank-guaranteed payment orders issued by companies. Sold at a discount, BAs can be redeemed at face value upon maturity (typically 30-365 days). The return on investment is the difference between the purchase and sale price, with interest rates slightly above government bonds due to bank backing.
• Commercial Paper: Similar to BAs but without bank guarantees, commercial paper is sold at a discount and redeemed at face value. Only highly rated companies can issue these, as payment relies on the issuer’s creditworthiness.
• Term Deposits: These provide guaranteed interest for a short time (less than a year). Early withdrawals usually come with penalties.
• Guaranteed Investment Certificates (GICs): Popular among risk-averse investors, GICs guarantee both principal and interest. While returns are typically low (rarely exceeding 1-2%), they’re reliable. GICs come in two types: cashable (can be redeemed early) and non-redeemable (locked until maturity). Interest rates for non-redeemable GICs are generally higher. Variations include:
  • Escalating-rate GIC: Interest increases over time (e.g., 0.8% in year one, 1.5% in year three).
  • Laddered GIC: The investment is split into parts that mature annually, offering flexibility for reinvestment or cashing out.
  • Installment GIC: Begins with a lump sum and grows through regular contributions.
• Index-Linked GICs: This type of GIC is ideal for investors seeking potential higher returns than standard GICs but with lower risk than full equity exposure. The interest is tied to the performance of another investment, such as equities, while the principal is guaranteed. However, because of this guarantee, the interest earned is typically lower than the full gains of the underlying investment, and there’s a chance you might not earn any profit at all. The typical term for index-linked GICs is three to five years or more. There are typically two types of Index-Linked GICs. One may simply have a guaranteed minimum and maximum amount for the said duration, the other may offer return based on a participations rate.

For example, if you purchase a one-year $100,000 GIC with a 1% interest rate, you are guaranteed $101,000 at the end of the term (your $100,000 principal plus 1% interest).

However, with an index-linked GIC (e.g., tied to the Canadian stock market index based on participation rate of 50%), if the index performs poorly or remains unchanged, you will still receive your $100,000 principal. If the index rises by 15%, you would receive your principal plus a portion of that increase. Banks and financial institutions generally keep a share of these profits due to the guarantee they provide on your principal. The percentage of the profit you receive is known as the “participation rate.” In some cases, a participation cap may limit the total profit you can earn.

For example, if you invest $100,000 in an index-linked GIC tied to the American stock index with a 50% participation rate, the outcomes after three years could be:

• If the stock market declines, you will still receive your $100,000 principal.
• If the market remains unchanged, you will receive your $100,000 principal.
• If the market grows by 20%, you will receive your $100,000 principal plus 50% of the 20% profit (or $10,000), totalling $110,000. In summary, if you find standard GIC rates too low but are risk-averse about investing directly in the stock market, index-linked GICs can offer a balance of security and potential for growth.
• Interest-Rate Linked GICs: Similar to index-linked GICs, but instead of being tied to equities, the interest is linked to the bank’s interest rates. If interest rates rise, your returns will increase; if rates fall, your returns decrease. This type of GIC offers flexibility in capturing potential rate increases while maintaining the safety of your principal.

In general, the interest rate on bonds is determined by the issuer’s risk and financial health. Government bonds tend to offer lower interest rates due to their stability, while companies with higher financial risks must offer higher rates to attract investors. For example, if Canadian government bonds yield 2%, financially strong companies might offer 3.5%, while companies with poor credit may offer -say – up to 10%.

Credit rating agencies like Moody’s and Standard & Poor’s evaluate and assign ratings based on a company’s risk level, ranging from AAA (lowest risk) to C (highest risk). Higher-rated companies pay lower interest since their bonds are seen as safer investments, while lower-rated companies must offer higher interest to attract buyers.

Investors generally balance their portfolios by buying both high- and low-risk bonds. High-risk bonds offer higher returns but come with a greater chance of default, while lower-risk bonds, although offering lower interest, protect the capital.

Equity Securities (Shares)

Equities are key investment instruments and historically provide higher returns than bonds over the long term. Unlike bonds, where returns are fixed and known upfront, equity returns depend on two factors: company dividends and stock price changes. When purchasing shares, you are buying part of the company and sharing in both its profits and losses. However, bonds are less risky because bondholders are prioritized over shareholders during liquidation in case of bankruptcy.

While bondholders are legally entitled to interest payments, dividend payments on stocks are not guaranteed and depend on the company’s board of directors. Many fast-growing companies, like tech firms, often reinvest profits instead of paying dividends, leading to increased stock prices over time.

There are two main types of shares: common shares and preferred shares.

Common Shares are widely recognized as securities that signify ownership in a company, granting shareholders a claim to its income and assets. Owners have the right to vote at annual meetings, influence the selection of the board of directors, and receive dividends. The value of common shares fluctuates based on the company’s performance and can drop to zero if the company is liquidated.

Preferred Shares, on the other hand, resemble bonds more than common shares. They are typically sold at a fixed price and provide guaranteed interest payments to shareholders. Preferred shareholders enjoy a higher claim on assets and profits compared to common shareholders, receiving dividends before any distributions are made to common shareholders. However, they usually do not have voting rights. The price of preferred shares is not tied to the company’s performance but rather depends on interbank interest rates. While interest payments are not legally mandatory like bond payments, failing to pay can harm a company’s reputation. If a company repeatedly misses these payments, preferred shareholders gain voting rights.

Example: Consider Company A, which offers two types of shares. The common share is currently priced at $20, providing a $4 dividend per share at the end of the year, while the preferred share is priced at $22, offering a higher $7 dividend.

If the company successfully doubles its common share price to $40 over two years, common shareholders with 50 shares (totaling $1,000) would see their investment grow to $2,000, plus $400 in dividends, resulting in a total of $2,400.

In contrast, the preferred share price would remain at $22, yielding $636 in dividends for a total of $1,636. While it may seem like preferred shareholders experience a loss, their guaranteed $7 dividend provides more stability during downturns. If the company struggles, common shareholders risk receiving no dividends and a drop in stock price.

Note: This brief introduction to common and preferred shares is just a starting point. Each type has many features and complexities, which could fill hundreds of pages. Always consult a financial advisor before making investment decisions.

Derivatives: Derivatives are financial instruments whose value is derived from one or more underlying assets. Typically employed by large investment firms to enhance returns and manage risk, these complex products can be based on various assets, including stocks, bonds, foreign currencies, futures contracts, indices, or inflation rates.

Derivatives are primarily categorized into two types:

1. Options
2. Forwards

Both are agreements between buyers and sellers and are specific to a time frame.

Options are divided into two types: call options and put options. Call options give the buyer the right to purchase a specified number of the underlying asset at an agreed-upon price. The seller of the call option is obligated to sell the asset at that price. This strategy is often used when an investor anticipates a significant rise in stock value but wants to limit their investment risk by opting for a less expensive call option instead.

Put Options: Put options grant the buyer the right to sell a specified number of the underlying asset at an agreed-upon price. In this arrangement, the seller of the put option is obligated to purchase the asset at that price if the buyer exercises the option.

For example, suppose you anticipate a rapid decline in your asset’s value but are uncertain. In this case, you might purchase a put option, akin to an insurance policy. If the market price falls below the option’s strike price, you can activate the contract, compelling the seller to buy your shares at the higher, predetermined price, thereby mitigating potential losses.

A Simple Scenario: Consider you have been tracking a bank’s stock for several months and have heard rumors of an impending merger with a larger bank, which could significantly boost the share price. However, you are not fully confident and prefer not to risk $100,000 in a direct investment. Instead, you could buy a call option on the bank’s shares. Let’s say the current stock price is $20. You could purchase a call option that allows you to buy the bank’s shares for $22 each within the next four months. The seller of the call option is obliged to sell the shares at this price.

If the entire contract covers 5,000 shares and the seller charges $2 per share for the option, your total cost would be $10,000. In this arrangement, the seller hopes the stock price remains below $22, enabling them to keep the premium while avoiding the sale of shares. Conversely, the buyer seeks the opposite outcome, hoping the stock price will surpass $22 to secure the shares at a discount.

If the stock price remains under $22, the option would not be exercised, and the seller retains the premium. However, if the price exceeds $22, the buyer would activate the option, purchasing the shares at $22. For instance, if the stock rises to $23, the buyer can sell the shares at the market price, yielding a profit of $1 per share. However, after accounting for the $2 premium, the final loss would be $1 per share.

Should the stock price rise dramatically—say to $40—the buyer stands to profit significantly. They would buy at $22 and sell at $40, resulting in a profit of $16 per share after subtracting the $2 option cost.

Notably, activating the contract requires only the initial investment of $10,000 for the option rather than the full $100,000 needed for direct stock purchases.

Important Note: Using options can provide leverage. If you had invested $100,000 to acquire 5,000 shares at $20 each and sold them at $40, your profit would double your investment, yielding a 100% return.

If you opted to use the $2 call option per share, your initial investment would only be $10,000, while your profit of $16 per share multiplied by 5,000 shares would total $80,000, equating to an impressive 800% return.

However, it’s important to recognize that while options offer substantial profit potential, they also come with significant risk. In this scenario, if the stock price drops to $15, your loss on direct shares would be $25,000, or 25%. Conversely, by choosing the option route, you would risk losing your entire $10,000 investment, representing a 100% loss. In a worst-case scenario, call option buyers can lose their full investment, while sellers face unlimited risk since share prices can theoretically rise indefinitely, obligating them to buy at any price to fulfill the contract.

Put option contracts function similarly to call options, with the seller guaranteeing the purchase of shares at the agreed-upon price upon the put option buyer’s request.

For the sake of brevity, I will refrain from delving deeper into the intricacies of options trading. A thorough exploration of options could easily fill hundreds of pages, which exceeds the scope of this introductory article.

2- Forwards

Many may be familiar with phrases like “The Brent crude price for January contract.” A forward contract obligates the buyer to purchase a product from the seller at an agreed-upon price. Unlike options, both parties are required to fulfill the contract. The underlying assets in forward contracts fall into two main categories: financial instruments (like stocks and bonds) and commodities (such as precious metals, crude oil, wheat, and corn).

Typically, no exchange occurs at the start of a forward contract. The seller delivers the product to the buyer, who pays the agreed price or settles the difference in cash. Most forward contracts are traded over-the-counter between large financial institutions.

Example: Consider a Toronto brewery that needs 100 tons of wheat annually. Since wheat prices fluctuate, the brewery signs a forward contract for 100 tons of barley to be delivered next January at $10 per kilogram. If the price exceeds $10 by the delivery date, the brewery can either receive the barley at the agreed price or receive cash for the difference to buy it elsewhere. This arrangement protects both the barley producer and the brewery: the producer secures a guaranteed buyer, while the brewery locks in a maximum purchase price.

Forward contracts have specific delivery dates and locations, which may or may not suit the buyer. For instance, if the Toronto brewery is near Montreal, it can request the barley on the due date. However, if the brewery were in Vancouver, it might opt for the cash difference instead, allowing it to source the barley locally. While forward contracts can be traded before the delivery date, physical delivery is required if one party demands it on that date.

This example illustrates the main purpose of forward contracts. In reality, many forward contract traders, including individuals and institutions, may not need the underlying goods. Many contracts are traded for profit, with traders closing their positions before delivery without taking possession of the physical product. Companies can also choose to settle in cash rather than take delivery, using forward contracts primarily to lock in prices for their intended products.

Forward contracts are primarily traded over-the-counter among large financial institutions like banks, but standardized versions are available on the stock market as futures contracts. When trading futures, both parties must deposit collateral in a shared account, which is monitored daily. This account adjusts based on price fluctuations, and investors should be cautious, as losses can exceed their initial deposits. Many traders mistakenly believe that futures contracts are equivalent to shares in oil companies, unaware that these contracts have expiration dates and may require physical delivery of the underlying product. Some have rushed to sell contracts before the due date to avoid delivery, leading to significant losses.