As published in The Financial Post on Oct 11, 2024 | Image: Freepik
Nothing lasts forever, and that includes rising inflation. Now, after a couple of years of ever-rising interest rates to tamp down inflation, headline inflation is easing. The latest July report came in at 2.5%, the lowest reading since March 2021 and Fed watchers expect another 25-basis point cut in interest rates at the Bank of Canada’s next meeting in September. This is good news as decreasing interest rates are supportive of bond prices, in general.
The changing interest rate regime should cheer small business owners, home buyers, and many investors. However, for GIC investors, there is a fly in the ointment: The tide is turning on those risk-free GIC rates that reached as high as 6% not long ago. Unlike bonds, whose prices rise when interest rates fall, GICs do not benefit from falling rates. Over the past 42 years, the FTSE Canada Universe Bond Index has outperformed GICs in all but seven years. (Morningstar) This is because yield alone does not equal total return when evaluating the performance of bond funds.
In this new interest rate environment, does leaning heavily into GICs still make sense? Is it time to reconsider the many advantages of bonds over GICs for achieving better overall returns?
Be Safe, Not Sorry
As its name implies, a guaranteed investment certificate (GIC), guarantees the full return of the initial deposit, plus accrued interest. GICs are insured by the Canadian Deposit Insurance Corporation (CDIC) up to $100,000 per each financial institution where they are purchased. (You could buy 5 GICs, each for a face value of $100,000 at 5 different financial institutions and, in total, they would be covered for up $500,000.) So far, so good.
Dig a little deeper, however, and there are 4 major drawbacks to an overreliance on using exclusively GICs for generating income over the long term.
Low liquidity: Typically, the longer the term, the better the interest rate on a GIC. During this lock-up period (for a non-callable GIC) you cannot easily access your money without foregoing interest earned. Cashing in a term GIC before maturity in this case may incur a significant penalty. This is a drawback should you need the funds prior to maturity date or want to take advantage of a better investment opportunity. A hefty allocation to GICs could therefore severely limit financial flexibility. By comparison, most bond funds whether mutual funds of ETFs are liquid. In the case of a daily valued mutual fund, the fund units can be sold, and the proceeds deposited in your account within a day or two.
Lower total return potential: Compared to other conservative investments, such as government and investment-grade bonds, the return on GICs is based solely on interest. Bonds, on the other hand, offer greater return potential over the long term because their total return is the sum of the interest rate (coupon) and any capital gains. Bond yield refers to the total return on a bond: coupon payments, plus potential capital appreciation, which has the potential to exceed yield depending on price movement over a given period.
In fact, the one-year total return difference in a decreasing interest rate environment can be significant. For example, a 3-year high quality bond with a 5% coupon and a current price of $99.8 would experience a 1-year total return of approximately 7.7% for just a 1% decrease in rates. Significantly better than the 1-year GIC rate of approximately 4%. The difference is even starker with a 7-year bond. In this case, a high-quality issuer with a 7-year 5% coupon bond priced at $100.287 today would realize an approximately 11% one-year total return (of coupon and price appreciation), for the same 1% decrease in rates. The lower total return potential of GICs versus bonds is therefore more pronounced in a decreasing interest rate environment.
Lower tax efficiency: Interest income is taxed at the individual’s full marginal tax rate in non-registered accounts—this can add up to double the rate on capital gains. A bond’s total return is a combination of interest and capital gains, the latter of which are taxed more favourably, making bonds a more tax-efficient option in non-registered accounts.
Higher reinvestment risk: GIC rates are more immediately influenced by Bank of Canada interest rate decisions than are bond coupons. When interest rates are falling—as they are now—when a GIC comes up for renewal, the offered rates are lower. Bonds, especially from corporate issuers can be more dependent on the credit worthiness of the underlying business. They may offer attractive risk/reward characteristics with competitive yields along with the potential for capital appreciation.
As ever, maintaining a sensibly diversified portfolio offers investors optionality to potentially smooth volatility, protect buying power, defend capital against unforeseen events, and to take advantage of attractive market opportunities. Bonds have earned their place as a sensible diversifier of returns over the long term.
