Are GICs a Good Substitute for Bonds?

Are GICs a Good Substitute for Bonds?

At high tide the fish eat ants; at low tide the ants eat fish.

~Thai Proverb

GICs vs. BondsStocks, bonds and cash are the three asset classes that most people consider to be the foundation of an investment portfolio, with stocks representing the most risky choice and cash, the least. Where do GICs fit into the mix? Some consider GICs (the Canadian version of U.S. CDs) to be part of your cash allocation. Others argue that many GICs don’t qualify as cash because you can’t always get instant access to your money. Some GICs are cashable, but you have to forfeit some or all of your interest earnings to get your money out.

In many ways, GICs are very similar to bonds. You invest your money for a fixed amount of time. You collect interest periodically throughout that period of time, and receive your principal back in full at maturity. The similarities between these two asset classes got me wondering whether we could choose to invest in GICs instead of bonds for our investment portfolio.

GICs vs. Bonds: What’s the Difference?

The ultimate difference between GICs and bonds lies in price. Bonds have two components: price and yield. You pay a certain amount for the bond and in return, you receive regular coupon payments. If you hold the bond to maturity, you get your principal back at the end of the term (provided that the issuer doesn’t default). While you hold that bond, its price will fluctuate on the open market. This won’t affect you unless you choose to sell the bond.

If, however, you choose to use ETFs (Exchange Traded Funds) or bond mutual funds as the vehicle for your bond allocation, your money will be susceptible to bond price fluctuations. Mind you, the fund manager will be buying new bonds regularly as the other issues in the portfolio mature, so that can take some of the volatility out of the price of the ETF or mutual fund. This is especially true for short term bond funds.

It’s also important to note that Management Expense Ratios and fees are especially relevant to bond funds, especially during a low-interest rate environment. If the bonds in the fund are yielding about 3% but the MER is 1% – 2%, you won’t be left with much in terms of returns. ETFs are generally a lot less costly, but you have to be aware of fees there as well.

What If Bonds Are Entering a Secular Bear Market?

Still, if you look at at chart of an ETF like the XBB that tracks a broad Canadian selection of bonds, you’ll see that you can get some fairly sizable price moves over time. Now if you’re investing for a very long period of time, that may be of no concern to you. But bonds investors have already been the beneficiaries of a 30-year secular bull market and that has some, including PIMCO’s Bill Gross, wondering if the tide is going out for bonds, at least for a while.

Bond markets generally experience longer secular cycles than equity markets, and they can take as long as 7 years to complete a topping process. Further, recent central bank policies have been extremely supportive for bond prices. There have been a few chinks in the QE armour of late, however, as bond prices have shown that they can fall even as Bernanke and company continue to buy billions of dollars in Treasury issuance. So a quick and protracted reversal of bond prices remains an elevated possibility, but is by no means a sure thing.

So the whole point of this little history lesson on the bond market is just to show that investing in bonds carries price risk, whereas GICs carry no such risk. When you purchase a GIC, your principal is guaranteed so long as you remain within the CDIC limits, and you don’t have to worry about price fluctuations at all.

Diversification

What about diversification? Bonds are supposed to act as a stabilizing force in your portfolio, rising when stocks hit a rough patch. While stocks and bonds can be negatively correlated during periods of crisis, they have been positively correlated with equity markets in general over the past 30 years. If you take a look at a long-term chart of the S&P 500 compared to the 30-Year U.S. Treasury, you can see that the main trend for both is upward, but that there are some points (usually in the midst of crisis) where they diverge. So bonds may or may not provide some measure of diversification, but GICs will always have no correlation to equity or bond prices because they don’t fluctuate in price.

How Do GIC Returns Compare to Bond Returns?

In general, the interest rates paid on GICs are roughly analogous to those paid by bonds of a similar maturity. In fact, I have occasionally been able to make a timely GIC purchase by watching the bond market because banks tend to be slow to respond to changes in the bond market, especially if they don’t go in their favour. ;) You just have to make sure you’re shopping for the best rates available, and you won’t usually find those at the big banks.

I was reading a good article in the Globe and Mail the other day about how Locking Up Your Money Can Be an Investment Crime. The author cited 3 ways that locking up your money can hurt you. I agreed with him on two of them: RESP scholarship funds? No thanks. Deferred sales charge mutual funds? Never again. But 5-Year GICs? I can’t agree that they put your money in prison.

The author’s point on 5-year GICs was actually a good one. Why would anyone want to lock up their money for 5 years at 2.1% when they could have instant access to it via a high-interest savings account that pays 2%? The problem is that he used a CIBC GIC rate, but a high interest savings account from a smaller financial institution. To compare apples to apples, it’s worth it to note that many smaller banks like ING Direct and Ally offer GIC rates that are quite a bit higher than the big banks, and do surpass the rates on their savings accounts.

Most of our 5-year GIC money is getting 3.00% – 3.25%. I know that’s not a lot, but for the safe component of your portfolio, it’s a little better than the 2% offered by the better high interest savings accounts and the next-to-nil rates you get at the big banks. If you create a ladder of 5-year GICs by buying more each year, you will eventually have some money maturing each year and will be able to take advantage of higher rates should they ever begin to rise in earnest. Also, many of the smaller financial institutions have more flexible GIC terms.

Our ING GICs are redeemable at any time, but we only receive 1% interest if we choose to redeem them before they mature. That seems fair to me. It provides us the peace of mind of knowing that we can access our money if we really need it, but just enough deterrent to keep us from tapping it for something frivolous.

What’s the Downside?

So far, I’ve made the case for why ditching bonds in favour of GICs is not such a bad idea. But what are some of the drawbacks? Actually, it comes back to price. The same factor that makes GICs a little safer is one of the drawbacks of forsaking bonds altogether.

You won’t lose any capital investing in GICs, but you will forgo any possibility of capital appreciation. Bond investors have made money over the past 30 years on capital appreciation as much as interest – maybe more so. If you choose GICs over bonds, you’ll miss out on some of the smoothing effects bonds can provide during stock meltdowns.

Having said that, after 30 years of price gains, you have to wonder how much longer the bond tide can rise given the limits imposed by the zero bound of interest rates. As usual, the answer is probably somewhere in the middle. Maybe it’s not a great idea to exclude bonds from your portfolio completely, but it might make sense to shift some of your bond allocation to a vehicle with less price risk like GICs depending, of course, on your individual GIC strategy and risk parameters.

These are the fixed income dilemmas swimming around in my head lately. Weighing most heavily on my mind has been this idea that high tide is over for bonds. I wouldn’t want our ship to run aground when the tide goes out.

What do you think? Are bonds near the end of their historic bull run or will economic uncertainty lift the tide a little longer?

Written by Kim Petch

18 Responses to Are GICs a Good Substitute for Bonds?

  1. I don’t know if you have Treasury Inflation-Protected Securities (TIPS) or IBonds in Canada, Two Cents. These are my favorite non-stock asset classes. I feel that they offer a better counter to stocks than bonds because they have inflation protection.

    The thing I am trying to do with my non-stock investing is to limit risk (I invest in stocks for growth). But bonds don’t do the trick because you can get killed by inflation. TIPS and IBonds offer a better counter, in my assessment. They are zero risk/low return asset classes in comparison to high risk/high return stocks.

    When stocks offer a good deal, I am in stocks. When stocks do not measure up to TIPS/IBonds, I am in TIPS/IBonds, waiting to get back into stocks.

    Rob

    • We have Real Return Bonds in Canada. They’re comparable to TIPS, but I don’t think we have anything that’s the same as IBonds. Maybe someone else can correct me if I’m wrong.

      I see what you mean about the inflation protection and there’s actually a professor named Zvi Bodie who advocates investing strictly in TIPS or RRBs (for Canadians). The only thing you have to remember is that RRBs or TIPS will fall in price if the rest of the bond market goes down. That’s not a concern if you buy individual bonds and hold to maturity, but it can be an issue if you invest in bond funds or ETFs.

      I was actually going to write about this on Wednesday. Thanks for your comments Rob!

  2. I just discovered the site, and me likey. I’ve already subscribed. Plus, we both have hilarious site initials (FU for me, BJ for you)

    I hold a 5 year GIC in my RRSP, which is the fixed income part of it. I think it averages 3.5% over the course of 5 years. The return isn’t that good, but I like the security.

    • :) Well, I’m really glad you like the blog, but I probably won’t think of its initials in quite the same way ever again.

      I’m a card-carrying nervous Nellie, so we hold most of our money in GICs at the moment as well. I sleep really well at night, even when despots are dropping like flies and oil is reaching for the stars.

      Thanks for reading!

  3. RE: “Investing in bonds carries price risk, whereas GICs carry no such risk.”

    This is an illusion. Yes, if you buy a five-year GIC at 3% and interest rates rise two years from now, your GIC won’t lose any principal. But the only reason you won’t see its market value decline is that there is no secondary market for GICs, as there is for bonds. If there were, you would certainly not be able to sell your GIC at par.

    You have still lost money, but the loss comes in the form of opportunity cost: your money is locked up in a illiquid investment earning less than the prevailing rate. That loss is less visible, but it’s just as real.

    • I actually don’t see that loss as just as real. You’re correct in that a rise in rates means your existing GICs aren’t earning as much as they could, but a good laddering strategy can ensure that you’re taking advantage of those moves. The GICs I own are redeemable, but you only get 1% interest if you redeem before maturity. Still, knowing that I can get out if I need to or trade up to a higher-paying instrument makes me feel better, especially if we experience some kind of swift uptick in rates.

      I’m willing to trade a little opportunity cost for safety. Opportunity cost is just a euphemism for risk, and there’s a place for that, but not in the safest part of my portfolio.

      Thanks for stopping by Mr. Couch Potato. :)

      • @2 Cents: It’s interesting that investors are OK redeeming GICs early and paying a penalty, but it would bother them to sell their bonds at a loss. I guess I just don’t appreciate the difference.

        Don’t get me wrong, I have nothing against a laddered GIC strategy. But when it comes down to it, short-term government bonds and GICs both have the same maturity risk (one to five years) and credit risk (both backed by the Canadian government), so they should provide very similar returns over most periods.

        • For me, the decision would depend on the particular situation and the actual loss. If I’m getting 1% interest to redeem a GIC that was only paying 2.5% in the first place in order to buy a new GIC that’s paying 5%, that’s worth it.

          Your point about government backing is a good one. Both have protection there. I just see GICs as less risky in the current environment, especially if the bond bull market is indeed coming to an end. But if you’re going to buy individual bonds and hold them to maturity, there’s probably not a huge difference. Most average investors, however, probably hold their bonds in the form of mutual funds or ETFs. There’s price risk there at this juncture of the bond cycle, so all other things being equal, I would probably favour a GIC ladder.

          I realize that’s a personal choice, though, and to each his (or her) own.

  4. I only own Strips, zeros and GICs as the income portion of my RSP. I don’t care about capital appreciation, as I hold until maturity. Bond ETFs are too sensitive to rising interest rates.

    Once you strip out capital appreciation from the equation, and selling, as well (I won’t retire for a while), it becomes a very simple equation: where is the best yield?

    Lately, (oddly), GICs from credit unions and life insurance companies have been offering much better rates than similar bonds.

    Remember GICs over five years long do not get CDIC protection. For short term money, whichever gets the best rate is my bet.

  5. This is basically what I do as well. I don’t have bonds in my RRSP portfolio but only 5 year GIC’s. They are laddered so I have one maturing every 3 months. In this way, I can have some money around if I need that for other investment needs.

    Of course, I don’t use big banks for my GIC’s. I go through a discount broker and get the best out of around 20 to 30 lenders in Canada, all are FDIC protected. Hence they have, in theory, same risk as government bonds. The interest rates that I got are usually 0.5% to 1% better than the bonds.

    Since this is for retirement, I don’t need the liquidity that I can have with the bonds. Since I won’t use the money for another 15 to 20 years, I am willing to give up the liquidity for a higher yield.

  6. For as long as I’ve managed money, there has always been the GICs vs. Bonds comparison. Each has their own merits as they serve to satisfy individual investor needs. From a practical and product knowledge perspective, investors can relate to the simplicities of a GIC. GICs can be easily purchased at your neighbourhood bank and once the investor has committed those funds for a particular period, they’ll get their money back upon maturity.
    There are many limitations on owning GICs. For example, by owning a GIC:
    • there is no liquidity;
    • CDIC may not be sufficient for your portfolio size;
    • proper term diversification cannot be achieved;
    • sector allocation or diversification is not possible.
    Liquidity for many may not be an issue, until a situation arises where cashing in a GIC becomes a reality. Owning a bond, or a bond fund, protects investors in these uncertain circumstances. The added benefit of owning bonds for those “do it yourself” investors or those who choose the professionally managed portfolios, is that bonds are extremely liquid investments. This liquidity allows for the portfolio to adapt to the changing market environment.
    Low interest rates has been the norm, subsequent to the initial bull run (i.e. drop in interest rates) in the case Japanese Government Bonds (JGBs), for almost three decades. Interest rates in North America has little reason to break from such an environment; consequently, as interest rates gyrate, there would the need to lock in attractive yields – say in the 10- or 30-year part of the yield curve – whereby GICs are not able to.
    Finally, should liquidity not be an issue (i.e. leaving investment allocated in fixed income for retirement), an actively managed bond portfolio – and not a laddered GIC portfolio – is one that would take advantage of where bonds (be it government or corporate) are cheap, or where anticipating a change in the economic environment may affect the shape of the yield curve. Invested in a well managed bond fund, not only will you be served with industry or sector diversification, but you will more importantly be properly managed with the right duration, which a GIC cannot do.

    • I can see your points on duration. Longer term GICs are few and far between. A few of the problems I have with bond funds, however, are as follows:

      - the fees tend to eat into already-meager returns
      - a rise in yields (fall in prices) can lead to substantial capital losses – especially if you need to liquidate at the wrong time
      - while you can sell a bond fund at any time, you may not like the price you get when you do so
      - an actively managed bond portfolio is only as good as the manager and I don’t think anyone can guarantee I won’t lose money

      In general, I find that bonds and bond funds offer less stability than GICs. In terms of liquidity, you just need to be careful that you have enough money in cash vehicles like savings accounts. You can also plan your GIC investments so that at least some of them are invested at institutions that have minimal penalties for cashing out early. ING Direct has a nice program.

  7. Credit unions are insured by the some provinces for more then 100,000 & I maybe for more then 5 years for GIC.

    I think Swiss annuities which can be cashed in @ anytime as well as Swiss money market claims are safer then GICs & or having money in the bank.

    Bonds are legalized theft. Goverments will @ some point not pay its bond holders.

    Some gold & or silver should be held in Switzerland to prevent conversation as well as owning property in Switzerland incase Canada becomes unsafe.

  8. If you compare say five year GIC’s vs. Bonds the GICs lose on losts of fronts.

    Taxes Government takes your earned income and can tax it up to 50%.

    The right bond fund and any gains can be treated like capital gains.

    Assuming the Government of Canada or Province of Ontario is still around the protection of GIC is no better.

    Right now net of fees YTD for conservative Bond funds is over 4%…GIC’s not so much. Want your money right away? GICs no way Bonds yes.

    • YTD bonds have done well – thanks to economic worries. That doesn’t mean that will continue. If you want your money right away and your bonds or bond funds happen to be lower in price, you’ll lose that money. I still prefer GICs – and I like that I don’t have to pay fees to an advisor to buy them.

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