Fixed-Income Investors: Is it Time to Switch from GICs to Bonds?
There are compelling reasons to invest in equities over the long term. So much so that academics in the field of finance will tell you that the traditional strategy of investors shifting an increasing balance of their assets to fixed income as they approach retirement is misguided. That argument was a lot more compelling after 2022, when neither stocks nor bonds were able to eke out a positive return.
Nevertheless, Canadians continue to invest in fixed-income products. However, as interest rates have increased, the inclination of many has been to shift from bonds or bond funds to GICs in response to poor performance from bonds and rates not seen in years from GICs. What caused this shift and are things about to change again?
Why Have Bonds Decreased in Value?
A typical bond, whether issued by a government or corporate entity, is a means by which the entity borrows money. Let’s say a corporate entity needs $100 million to expand a factory. The corporation would typically approach an investment bank to facilitate the bond issue. In Canada, two of the biggest such “underwriters” are RBC Capital Markets and TD Securities. They would investigate whether there is interest in such a bond issue and set a coupon rate for the bond among other things. For our purposes, we will focus on the coupon rate.
When first issued, bonds are generally sold at par. In other words, a bond issued in $1,000 increments will cost $1,000 to buy. This is also referred to as the face value. If the coupon rate is 5%, that means the bond pays $50 per $1,000 of face or par value (1,000 x 5% = 50) per year until maturity. This coupon rate is set based on what bonds of similar characteristics, quality and maturity are being traded at in the same period. This coupon rate is set at issuance and stays the same throughout the life of the bond.
When a bond is bought at face value and held to maturity, the yield is the same as the coupon rate. However, once a bond issue has been sold, it can now be traded on the so-called secondary markets. It’s now “in the wild” so to speak and is subject to changes in market expectations and prevailing interest rates.
If prevailing interest rates go up, as we experienced with our recent bout of inflation, that 5% coupon rate may not be perceived as adequate compensation. Someone who owns that bond but who wants to sell it may have to discount the price to get someone else to take it off their hands. Let’s suppose that equivalent bonds are now being issued with 6% coupons. To be able to sell the bond with the 5% coupon for the equivalent yield, the owner would need to sell it for about $930 versus the $1,000 that was originally paid. The buyer will continue to get the $50 coupon paid, just like the seller did, but will have bought the bond at a lower price, effectively increasing the yield. In addition, when the bond matures, the owner will be paid back the full face value of the bond, $1,000, so there is an extra $70 to be made there as well. What’s more, that $70 will be treated as a capital gain, not interest, so there is a tax advantage if the bond is held in a non-registered account. This combination of interest payments and the capital gain is known as the yield to maturity.
To return to the situation we were in last year, when bonds lost value, because of the increase in interest rates due to inflation, all the bonds that were held in the bond funds lost value. Virtually every bond became a discount bond, and every bond fund became a discount bond fund. You can easily see that by looking up your favourite bond ETF.
You can see that the weighted average coupon of each of these ETFs is significantly less than the weighted average yield to maturity. Just to clarify, the “weight” refers to the relative size of the various bonds held within each of these ETFs. XBB holds 1,576 bonds, ZAG 1,566, and VAB 1,197. There will be a lot of overlap in those numbers, but they are different because each ETF follows a different bond index. The point is that you get a fairly good picture of the overall bond market in Canada by looking at these three broad market ETFs.
Duration is a measure of how sensitive a bond’s price is to changes in interest rates. A bond ETF with a higher effective duration is more sensitive than one with a shorter duration. Although the calculation is a bit complex you can think of duration as the weighted average of the time it takes to receive the bonds (or bond fund’s) cash flows. A bond that has high interest payments and a short maturity will have a short duration. It will therefore be less sensitive to changes in interest rates because investors get their money back sooner. On the other hand, if the interest rates are lower or the maturity is longer, the duration will be longer because more of the return from the bond is “backloaded,” and is, therefore, riskier. This also explains why longer-term bonds usually have higher interest rates. Because there is more risk in a long-term bond, potential buyers will demand greater compensation.
Bonds are issued with different maturity terms. These ETFs hold bonds with a wide range of maturities but the average inside these bonds is about 10 years, again weighted according to the relative size of the bonds held.
What About the Inverted Yield Curve?
I just mentioned that typically, long-term bonds have higher yields because of the associated risks. However, current yields are quite the opposite.
Inverted bond yields are not uncommon following inflation. The Bank of Canada and other central banks generally set the rates at the short end. This “tightens the money supply,” and tends to put downward pressure on inflation. Expectations that inflation will settle down in the next year or two lead to lower expected yields farther out in the future.
How are GICs Different?
Unlike governments or corporations that are borrowing to fund spending or raise capital, Guaranteed Investment Certificates (GICs) are issued by financial institutions to fund lending. The major banks are well-known for their GICs, but other major lenders are the lower-tier banks and trust companies such as Equitable Bank, Home Trust Company, and HomeEquity Bank (home of the CHIP Reverse Mortgage).
The Type of Product
GICs and bonds are individual products. However, Canadians own bonds largely through mutual funds or exchange-traded funds. Individual bond purchases are seldom economical for retail investors. GICs, on the other hand, are aimed at retail investors and are not available packaged into a fund.
Furthermore, bonds are securities that are subject to a risk of default while GICs are deposit products that, within prescribed limits, are insured against default by the Canada Deposit Insurance Corporation (CDIC).
While bonds fluctuate in price and can be traded on the open market, GICs are bought from the issuing financial institution and are not tradeable. Nor are they redeemable before maturity. Unlike bonds, therefore, GICs are an illiquid product. For that reason, they often provide higher yields compared to bonds of similar maturities. In addition, the yield is set at the date of purchase and does not change throughout the life of the term.
Bonds are issued with a variety of maturities stretching out as far as 40 years or more. In contrast, while GICs with maturities greater than five years are becoming more available, most GIC terms do not go beyond five years.
Bonds are often purchased to generate income. Although different arrangements are possible, including the zero-coupon bond, the classic bond pays interest semi-annually. So, referring back to the bond with the $1,000 face value and 5% coupon, it would make a payment every six months of $25 or $50 in the year. At the end of the term, the last payment would include the return of the principal, $1,000, and the final coupon payment of $25.
GIC interest payments can be arranged in a variety of ways. A bond with two or more years to maturity may pay interest on the anniversary date each year or the interest could compound and pay out with the principal at maturity. Some issuers also offer the option of semi-annual or even monthly payments.
How are interest rates trending and what difference does it make?
As many Canadians are acutely aware, while inflation has been high in the last year, it has begun to trend downward. As a result, interest rates on GICs and bond yields have also begun to trend lower. Relatively speaking, this tends to make bonds look more attractive than they were previously. The reason bonds did so particularly well for decades past is because there had been a gradual decline in interest rates. Bonds would be issued at a certain rate in one year and over the following year, interest rates would decline. This would boost the price of the bond because it carried a higher coupon rate, causing it to trade at a premium (the opposite situation of the discount bond mentioned earlier) compared to the bonds issued in subsequent years. Then 2022 and 2023 rolled along causing coupon rates and bond yields to increase to levels not seen in many years. Now, with inflation and prevailing interest rates beginning to abate, the bonds that were pushed down in price are becoming more valuable again.
On the other hand, for GICs when interest rates go down, the interest rates that are offered begin to decrease. Given that GICs are not tradeable, there is no corresponding increase in price. What should a GIC investor do?
It might be time to consider shifting more of your fixed-income assets to bonds. I am hesitant to say this, lest I be accused of market timing, but I think a trend is beginning to emerge. Five-year GICs were available through my online brokerage at over 5.2% as recently as October 2023. Today (January 8, 2024) the best rate available on a 5-year GIC is 4.16%. At other institutions, I’m finding rates of 4.25% and 4.85%.
The argument for bond funds might make especially good sense if you are holding fixed income in non-registered accounts and you are thinking not just of the interest payments but the total return. As mentioned, the current situation of most bonds being in a discount situation means that new purchases will result in yields that in part from capital gains, causing greater tax efficiency than you would typically experience.
If on the other hand, you wish to stay with GICs, then you may want to look to the “off-brand” financial institutions for higher rates. Despite their lower-tier status, they have the same CDIC coverage and, therefore, the same guarantee you would get from Royal or TD, etc.
This is the 230th blog post for Russ Writes, first published on 2024-01-08
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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.
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