Are GICs a Good Substitute for Bonds?

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

~Thai Proverb

Stocks, 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?