In today’s economic landscape, prudent personal finance is very crucial. Due to record-high inflation from massive money printing and quantitative easing, the traditional formula of bank savings till 60 might not suffice. While equity markets are a great way to build wealth and offer substantially higher returns than most banks, debt securities, and government securities, it is vital to diversify one’s portfolio with low-risk assets such as GICs and bonds due to their stability.
GICs and Bonds are some of the most popular low-risk assets in Canada. We will discuss the pros and cons of both to decide which one fits your investor profile better.
What are GICs?
Guaranteed Investment Certificates are a type of debt security popular in Canada due to their low-risk profile. They are similar to Certificates of Deposits that are offered in the US in principle. The biggest buyers in Canada of GICs are retirement plans and retirement funds, as they are backed by the Canadian government to a large extent and offer low-risk returns.
GICs are issued by financial institutions and used as a fundraising tool by them. GIC investors are, in essence, loaning money to these institutions in place of interest. Interest rates offered by GICs vary over different maturities; rates are generally higher over longer time periods. GICs are backed by the Canadian government up to C$100000, meaning that it is the government’s obligation to cover any capital loss up to that amount.
Pros of GICs –
No risk of capital loss
Since GICs aren’t traded publicly like government-issued bonds, capital losses or gains are no risk. Thus, adding the government guarantee on GICs creates a very low and attractive risk profile.
GICs are very flexible in terms of returns. There are two types of GICs, fixed-rate and floating rate. Fixed-rate GICs deliver a return that is fixed when the GIC is issued. On the other hand, floating-rate GIC returns are dependent on certain indexes, such as a stock index that tracks a country’s biggest companies or the rate on treasury bonds or government securities. Interest rates terms vary from monthly, semi-annually, annually, or payable at maturity. There are also various redemption terms available, thus giving the investor options about how long they want to be invested. Laddering is another method used by investors to increase flexibility when investing in GICs. Since GICs offer different rates of returns over different time periods, investors can spread their money over different time frames to increase their returns.
Since GICs are bought directly from issuers, there are no fees for investing in them.
Cons of GICs
Low Real Returns
While GICs are a worthy alternative to bank savings due to lower fees and a low-risk profile, they are inferior performance in real returns. Real returns take into account inflation over the period of investment. In real terms, GICs lag inflation.
Unlike bonds that traders can sell at will, GICs have a lock-in period over which any redemption requests result in hefty penalties. Hence investors should plan their financials well before agreeing to lock in money over the term of the GIC.
Equity markets in Canada have generated north of 9% a year on average for investors over the past 60+ years. Hence, investing too much in low return GICs will result in humongous opportunity costs. Therefore, we recommend that investors only use GICs with other investments or as a hedging tool and not assign a substantial portion of their portfolio to them.
What are Bonds?
Bonds are very similar to GICs in principle. Governments or financial institutions issue them to raise funds from investors willing to lend in exchange for interest.
However, a major difference between the two is that in most cases, bonds are publicly traded, meaning investors have liquidity even if their principal is locked for the bond’s tenure. As a result, bond investors are exposed to capital gains/losses as bond prices are affected by various factors such as equity market performance, the prevailing interest rate, foreign exchange rates, and other economic factors.
As bonds are publicly traded, experts manage various passive vehicles such as ETFs and bond funds. These funds allow investors to invest in bonds passively and cheaply.
Bonds are usually evaluated based on their issuers. There is an inverse relationship between the quality of the issuer and the interest paid on the bond; the better the issuer (e.g. governments), the lower the interest rates. In addition, all bonds come with a rating that informs investors about the probability of default; ratings range from AAA (practically risk-free) or BB (junk status or high chance of default).
Some of the most popular bonds globally are treasury or government-backed bonds, as they have the lowest probability of default and offer meagre returns. However, bonds are also issued by corporations, such as tech companies (Apple) and financial institutions (TD).
Bonds offer investors liquidity as they are publicly traded, thus giving investors an option to get their money back without paying hefty penalties. In addition, major bonds such as treasury and government bonds have very deep markets, meaning spreads are low, and there are always buyers available.
Multiple Issuer Options
While GICs are only issued by financial institutions and government-backed entities, bonds can be issued by corporations of any type. This gives investors an option to spread/diversify their bond portfolio across different industries. Also, building a portfolio of bonds with different maturities, ratings and issuers can help investors generate higher returns than GICs and lower their risk.
As we mentioned before, there are multiple options for indirect investing due to bonds being publicly traded. In addition, bond funds and ETFs are managed by experts who can generate higher returns at lower risk than novice investors. Further, bond funds and ETFs are not only cheap and simple but also very liquid.
Bonds are not as safe as GICs as they are publicly traded. Investors are exposed to capital gains and losses depending on the going price of the bonds they hold. In addition, as mentioned above, bond prices are affected by various economic and political factors.
Not as Safe
While The government backs gICs up to C$100,000, not all bonds are insured by the government. Therefore, investors are exposed to credit risk in bonds where the government is not a guarantor.
Bonds vs GICs – Which Offer Better Returns?
GICs and bond returns are heavily dependent on type and issuer. For example, GICs by financial institutions generally offer higher returns than those issued by the government due to the higher risk involved. The same goes for bonds. For example, a bond issued by Apple or TD is bound to offer higher returns than those issued by the government.
In Canada, government-insured/registered GICs currently offer between 0.6%-2.4% returns annually, depending on tenure. For example, a 1-year GIC by CIBC offers 0.65%, a 5-year GIC by Oaken Financial offers 2.2%, and a 10-year GIC by EQ Bank offers 2.4%. Other factors also affect GIC returns; for example, redeemable GICs offer lower rates as the investors get more flexibility.
The Government of Canada 10 year bond currently offers 1.65% on average over 10 years. On the other hand, the best bond ETFs are by far higher return options for investors looking for low-risk assets. For example, the Vanguard Canadian Bond Index ETF and the iShares 1-5 Year Laddered Canadian Bond Index ETF offer 3.13% and 2.57% returns. Further, these ETFs hold only government-issued bonds, meaning that credit risk is near zero.
There are also high-quality corporate bond ETFs that only invest in bonds with high ratings and top-quality issuers. These bonds offer returns in the 3.5%-4.5% range. For example, Vanguard Canadian Corporate Bond ETF offers 3.63%, and the iShares Core Canadian Corporate Bond ETF offers 4.43%. Finally, bond ETFs have higher returns and moderately higher risk; for example, Vanguard Canadian Long-Term Bond ETF offers 5.23%, while the iShares Core Canadian Long Term Bond ETF offers 5.61%.
As you can see, there are plenty of options for investors seeking low-risk assets. However, most investors don’t understand or are not familiar with the concept of real returns/inflation-adjusted returns. As of yesterday, the Canadian annual inflation rate has reached a record 3.7%, meaning that most low-risk assets will deplete wealth due to lower purchasing power.
We would advise interested investors to allocate only a portion of their portfolio to low-risk assets as a hedging tool/means of diversification to ensure that inflation does not erode their wealth. The best solution would be a mix of index ETFs/index funds, bond ETFs/bond funds, GICs/bank deposits, and commodities such as gold (as they move with inflation).
Gic Vs Bonds
For income-oriented Canadian investors, the difference between fixed-income and high-yield bonds is more important than ever. One of the biggest challenges for fixed income investors in the US is the drop in prices that funds and ETFs can suffer when interest rates rise. Sources: 6, 8
This is because bond prices move in contrast to interest rates, and long-term bonds are more vulnerable to rising interest rates than short-term bonds. Similarly, bonds that earn interest over their maturity tend to pay a higher interest rate than those that yield slightly more, such as 10-year bonds. Sources: 7, 12
The ability to switch bonds and make capital gains at any time before maturity, when interest rates fall and liquidity increases, offers bond investors the opportunity to achieve better returns than banks “GICs. Sources: 4
Note that a bond ETF with a higher average maturity than the GIC ladder can assume that it carries more risk. For corporate and government bonds, there is a risk that inflation will be higher than any interest rate paid by the bond, meaning that your investment will not keep pace with the cost of living. As interest rates fall, the market value of bonds will rise as bond interest payments become more attractive to investors. If the “GIC” ladder bonds in your ETF have similar long-term expected returns, your annual fixed income will be benchmarked and compared with the bond indices. Sources: 2, 9, 12
When interest rates fall, and newly issued government bonds account for only 1.5%, you can see $2 bonds becoming much more attractive, while $1 bonds do not. Sources: 5
Figure 2 illustrates the interest rate difference between $1 bonds and $2 bonds over the same period, as shown in Figure 2. Sources: 3
This means that the accrued interest rate on a maturing bond in a GIC would be lower than the current rate. A stripe bond with zero-coupon A or without coupon is a bond that the issuer repays to the investor at the same rate at which the bond matures. For a typical bond, the interest rate set at issue, based on the average annual return on the principal and interest rate, does not change during the bond term. Like the Gic, this bond sets a time frame for when a capital investment will return. Sources: 3, 6, 9, 11
Bonds and investment trusts carry higher charges, which usually mean you get fewer returns. It can be difficult to guarantee a good interest rate on bonds and gilts, but you can start by comparing three or four providers to find the best rate for you. One last factor to consider is the comparison of the Gic’s. If you choose one of the higher-yield strategies of a smaller institution, the return is increased with a small additional risk to keep costs down. In comparison, you opt for a more expensive bond of a larger institution such as hedge funds or mutual funds. Sources: 0, 4, 7
The GIC ladder is more like a portfolio of short-term bond ETFs than a bond ladder and thus has a much higher risk granularity. Strategies studied included investing in lower-rated bonds, investing in fixed income securities with maturities of 1-5 years, and investing on a ladder. Generally, the ladder will have a higher yield than GICs and a lower risk of loss than bonds. Sources: 2, 6
As for the latter, the main advantage of buying long-term government bonds is that you do not suffer significant capital losses if interest rates rise if you sell your bonds before maturity. If the interest rate goes down significantly, you can sell the bonds at a profit when they mature. Sources: 0, 5
If you decide to sell your bonds before maturity, you risk losing some of the capital of your investment if interest rates rise. If you sell the bond before maturity, you will receive a lower return on your capital because the value of your bond will decrease when interest rates rise. Sources: 0
High-yield bonds can be offered with a coupon, but the coupon price can fluctuate, offering a higher yield than bonds. Sources: 10
For example, many bonds have daily-changing interest rates, known as fixed rates, making them more attractive to investors than high-yield bonds. As described above, bonds (and bond ETFs) can fluctuate in price by simply increasing the value of the GIC daily while interest is incurred. Bond prices rise when interest rates fall because fixed interest rates make the bond more attractive than the current rate. Sources: 2, 4, 12
The logic is the same: a 2% coupon bond is very attractive to investors because newly issued bond yields higher. If you’re not against a riskier investment with more liquidity, bonds may be a good option. Bonds are available over the long term, which increases risk, but can also yield higher returns than high-yield bonds such as the GIC and G-bond ETFs, but the logic behind this is sound. Sources: 0, 1, 5
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