Bonds or GICs: Which is the better fixed-income investment choice?
Interest Rates and Borrowing, Including Mortgages
In the last several months, we have begun to see home sales decrease and prices drop, largely due to an increase in interest rates. If you are planning to borrow money, whether for a mortgage or other purposes, this increase in rates is unwelcome news. House prices tend to be a bit “sticky” at least for a while, as most homeowners are reluctant to sell for a loss unless they have to. If you have already borrowed, and you’ve gotten in at a low fixed rate, you might be smiling, especially if you are confident that you will be staying in your current home for 15 years or more.
Interest Rates and Lending – Fixed Income Investing
Not everyone is a borrower, of course. Some people are lenders. Here, I am not talking about banks, credit unions, or trust companies. I am talking about people who buy bonds, related fixed-income securities, or GICs. These are all kinds of debt instruments. To you and me it is a purchase. To the entity that sells the bond or GIC, these represent loans on which they owe interest and eventually have to return the principal. With the general increase in prevailing interest rates, to attract lenders these entities need to raise interest rates.
The End of “TINA”?
This increase in interest rates has suddenly raised all kinds of interest (no pun intended) in fixed income (a blanket term to cover various debt instruments) as an investment product category. In the last couple of years, interest rates have been so low that many would make the “TINA” argument: that is, “There Is No Alternative” to equity investing. The returns from fixed income were too low. Of course, in the view of some, the returns may still be too low as inflation is running higher than almost any fixed-income product available. However, on the assumption that inflation will begin to reduce by the end of this year or in 2023, now may be the time to consider fixed income anew.
Some Points of Comparison: Bonds and GICs
When I worked in the direct investing or DIY investing world, I would occasionally see some accounts in which individual bonds were held. More often, however, I saw bond funds, either bond mutual funds or bond Exchange-Traded Funds (ETFs). The other common product I saw was the Guaranteed Investment Certificate (GIC). For the remainder of this post, I will compare the relative value of one versus the other. To simplify things and to most closely compare one product type to the other, I will compare short-term bond ETFs to GICs.
Depending on how much effort you want to go to, returns from bond ETFs have been close to the same as they have been from GICs.
Here is a table of rates I was able to find from several short-term bond ETF issuers.
These are the latest rates I could find, and since I am writing after a holiday long weekend, they date from Thursday, June 30, 2022.
You will note two columns with rates, the weighted average coupon, and the weighted average yield to maturity. A bond fund contains a collection of bonds within it. Depending on the formula used by the ETF issuer, each bond may represent a different proportion of the overall fund. This is why the term “weighted average” is used. For a very simplified example, think of a bond fund consisting of only three bonds. Let’s say the bond fund is worth $100. One bond is worth $50, the second bond is worth $30, and the third bond is worth $20. The bond worth $50 would have a 50% weighting, the bond worth $30 would have a 30% weighting, and the bond worth $20 would have a 20% weighting. BMO’s ZSDB has only about 100 bonds in it, but the other three ETFs have over 400 bonds each, so individual bonds have little individual influence.
The coupon has to do with the interest rate payable relative to its par value. Par Value is always 100, which you can view as meaning 100%. On average, the bonds in these four ETFs were originally issued at an interest rate of 2.11%. However, if you were to have bought these four bonds on Friday, June 30, 2022, excluding any commission costs, you could expect to generate a return of about 3.60%.
Why the discrepancy? Unlike GICs, bonds fluctuate in price so that the interest payments of already-issued bonds are equivalent to the interest rates of bonds being issued today. If a bond was issued with a coupon payment of 2.11%, but prevailing interest rates mean that a bond of substantially identical characteristics is generating payments averaging 3.60%, then the already-existing bond has to have its price discounted to equal the same payment as an equivalent newly issued bond. Since the weighted average coupon is less than the yield to maturity, you can see that the bonds inside these funds are all discounted from their original par value. In essence, your return over about 3 years would consist in part of interest payments with the balance being made up of the increased value of the bonds for those years. That difference would be a capital gain.
Immediately below is a table of rates for monthly-pay GICs that date from Thursday, June 30, 2022 from TD Direct Investing. As they come from a discount brokerage, these are “brokered” GICs. In other words, they are not sold directly from the issuer. I chose the monthly payment rates, as the ETFs listed above are either monthly-pay or quarterly-pay.
You will note that the rates of return are significantly better for these GICs than they are for the bond ETFs. As mentioned, these particular GICs are available at a discount brokerage, the same place where you can buy bond ETFs if you wish.
If you are inclined to complicate your life for even better returns, some online banks will provide even better rates. One of the consistently best issuers in this regard is Oaken Financial. Again, rates are for their monthly pay GICs, which are 0.10% worse than their annual pay GICs.
You will note that the average maturity for a “ladder” of 1-to-5-year GICs is 3 years, almost identical to the average maturity of 2.97 years for the short-term bond ETFs. If you are inclined toward a longer time horizon, bond ETFs that typically have the name “aggregate” or “universe” in them hold bonds with average maturities closer to 10 years. Generally speaking, longer bonds produce better yields than bonds with shorter terms, but they also tend to react more strongly to increases in interest rates.
Taxation and Appropriate Account Types
Some will argue that since bonds and GICs pay interest and they are therefore taxed at the same rate as ordinary income, you should put those types of investments in tax-sheltered accounts like RRSPs and TFSAs. Conversely, you should put equity investments in non-registered accounts since dividends and capital gains are taxed more favourably.
In general, I think that strategizing over asset location is a mistake and you can read more here over my reasons why. However, if you are debating over the type of fixed income asset to locate in which account type, then I do have an opinion. Let’s say that you have settled on a 60/40 equity/fixed income asset allocation. By that I mean you have decided that, regardless of account type, you will hold 60% of your assets in equities (stocks) and 40% in fixed income (bonds, GICs). It can make a meaningful difference over whether to hold GICs or bonds in a non-registered account. Or at least it did until last year.
As I noted earlier, when interest rates go up, new bonds are issued at higher rates, while older bonds that were issued at lower rates will have to be discounted to offer an equivalent return for the investor. However, when interest rates go down, as they had been doing quite steadily for many years, bonds that were issued earlier at higher rates are sold at a premium because the seller can command a higher price in the marketplace. When held in a non-registered account, premium bonds that are bought at a high price but eventually mature at par generate a capital loss. So, you get higher regular payments, which cause you to pay additional tax, while simultaneously generating capital loss to offset the higher interest payments. Interest payments are taxed at a higher rate while capital losses are claimed at half the rate. That’s not an issue in an RRSP or TFSA, but it sure is when there are tax implications for every transaction.
There are two solutions to this problem. One is to buy GICs which are always bought and sold at par. They do not fluctuate in price regardless of the length of the term. Capital gains or losses are therefore not a factor.
The second solution is to buy a discount bond. That is, you buy a bond that is trading at less than par. Not too long ago, i.e., last year, that was becoming increasingly difficult. The Bank of Montreal (BMO) has a couple of discount bond ETFs, one mentioned above, ZSDB, which holds bonds with maturities between 1 to 5 years that trade at less than par, and ZDB, which also holds longer maturity bonds that trade at a discount. Otherwise, almost all the bond funds that you could buy held premium bonds because prevailing interest rates had dropped so low. Now, however, as rates have increased, most bonds are trading at a discount. The BMO discount bond ETFs, ZSDB and ZDB, are simply trading at greater discounts. To get an idea, look at the ratio of the coupon rate to the yield to maturity. The average coupon rate of 2.11% divided into the average yield to maturity of 3.60% yields a figure of 58.61% (2.11/3.60). ZSDB, the short-term discount bond ETF, yields a figure of 46.37% (1.79/3.86). That means that as the bonds within the funds mature, a greater proportion of the distributions will come in the form of capital gains versus interest payments, making the bond or bond fund with the greater discount even more tax efficient.
Bond ETFs can be sold at any time in any proportion, as long as the market is open. You can sell a few shares of the ETF, or you can sell the entire amount.
While cashable versions of GICs are available, the rates are much poorer, in the range of 1.70 to 2.00%. Otherwise, you are locked in until the maturity date. If you have $100,000 in GICs and you divide them into a 5-year ladder, you will have $20,000 come due each year, so that mitigates the issue somewhat, but if you need more than $20,000, you are still stuck. An alternative is to reserve a portion of your fixed-income allocation to more liquid bond ETFs, giving up some yield for the sake of greater liquidity. How much should go in bonds? Here I borrow directly from the folks at PWL Capital. This graphic from Justin Bender and presented in a video by Ben Felix suggests this rule: “Hold enough of your portfolio in liquid bond ETFs to allow you to rebalance back to your target asset mix in the event of a 50% stock market drop.”
Look at the situation on the far right as an example. Let’s suppose you hold exactly the proportions indicated: 80% stocks, 8% bonds, and 12% GICs. Let’s suppose your account is worth $100,000. The $80,000 allocation to stocks is cut in half (50%) down to $40,000, while the bond and GIC values remain the same. The new value of your account is down to $60,000 ($100,000 – $40,000). The GIC portion of your fixed-income allocation is locked in, but fortunately, you can sell the bond ETF to rebalance back to your original asset mix. Here’s what that process looks like:
As the above illustration concerning liquidity shows, one of the biggest advantages of bond funds over GICs is that you can hold a single fund that will constantly renew over time as the bonds within mature and are replaced with new bonds. Furthermore, at a brokerage firm, you can hold the bond fund in the same account as your other investments. GICs, on the other hand, are locked into certain specific maturities and have to be managed. If you have a 5-year GIC ladder, you will only have to decide once a year, but some people have GICs with maturities twice a year, quarterly, or even monthly. Theoretically, over five years, you could easily have (5 years x 12 months) 60 GICs with maturities occurring every month. If you have the time and inclination, that could be perfectly fine, but not everyone may enjoy that kind of work.
Security of Your Money
Here is where GICs have their appeal over bonds. While bonds issued by governments have minimal risk, bonds issued by corporations can and do default from time to time. If that is the case, you wind up as a creditor, hoping to get back a part of what you invested.
GICs by contrast are “guaranteed.” They are risk-free within certain limits. In Canada, and at registered banks, that guarantee is provided by the Canada Deposit Insurance Corporation (CDIC). The magic number is $100,000, but that can be expanded, especially in the case of brokered GICs, since you can buy from multiple issuers.
There are legitimate reasons to prefer GICs over bond funds. Balancing those reasons – returns, maturities, taxation, account types, liquidity, simplicity, and security – can hold more weight for one investor than another, but they all deserve your attention.
This is the 154th blog post for Russ Writes, first published on 2022-07-04.
Click here to contact me for an appointment.
You may be interested in a half-hour no-cost, no-obligation financial planning conversation with me. Click here to sign up for a free session of FinPlan30.
Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.