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Bonds and Bond Funds vs Bank Guaranteed Investment Certificates (GIC’s)
Over the last 1, 5 and 10 year periods, Canadian government bonds have outperformed the 5 year bank GIC’s after all fees. Bond returns consist of both interest income and capital gains, while the GIC return is only interest income. Canadian GIC returns are provided by Stats Canada, while the Canadian benchmark total return figures are from both the Canadian DEX Bond Universe and the DEX Short Term Bond Universe numbers.
The capital gain component of bond returns makes them perform very differently to bank deposits and GIC’s. Bond prices typically fluctuate in the opposite direction to interest rates. When interest rates decline, bond prices rise as the fixed coupon yields makes them more attractive compared to current interest rates.
On the other hand, the value of GIC’s in the market place always remain the same regardless of the changing level of interest rates.
For investors not comfortable with daily price changes, GIC’s offer the appearance of more stability. If interest rates should move up sharply, bond investors will see falling prices and may actually experience negative returns as was the case in 1999. However, if the economy and the rate of inflation start to slow down, interest rates could eventually go down once again, providing bond investors with capital gain opportunities.
Credit quality for GIC’s is provided by the Canada Deposit Insurance Corporation, CDIC, who insures eligible deposits at member institutions up to $100,000 per depositor. One must keep in mind that CDIC guarantees the principal only, not the interest and that the insurance is for a total of $100,000 per depositor and not per deposit. For example, if an individual has two separate GIC’s for $100,000 each at the same member institution, CDIC only provides insurance up to $100,000 per person, not per specific deposit.
Depending on the type of bond or bond fund purchased, credit quality will differ materially from GIC investments. While CDIC insurance is not available to bond investors, government of Canada bonds represent an obligation of the federal government to repay the principal, while GIC’s offer a promise from a crown corporation (CDIC) that is in turn guaranteed by the federal government. Consequently, professional bond investors managing large pension and mutual funds view the credit quality of Canadian government bonds as superior to any bank GIC’s.
Corporate bonds offer a different type of credit risk. They do pose varying degrees of default risk depending on the quality of the corporation issuing the bond. Well financed companies like banks and insurance companies typically provide higher returns than both GIC’s and federal and provincial bonds, yet the default risk is only marginally higher. On the other hand, low quality bonds typically provide higher returns but trade like stocks and offer little creditor protection in case of bankruptcy.
In order to minimize any default risk from an individual corporate issuer, investing in a mutual fund of corporate debt is a much safer option than purchasing one or two corporate bonds.
Most bond investments are liquid and depending on their credit quality can be sold any time before maturity. On the other hand, GIC’s cannot be sold before maturity unless one purchases the lower yielding cashable type or the investor dies before maturity. While these differences appear subtle, the opportunity to get back your money on demand is a definite advantage over GIC’s. One must keep in mind that cash proceeds from a bond sold before maturity may not match the amount invested, but will be a reflection of what current yields are at the time of sale. This may result in a capital gain if interest rates have dropped from the date of purchase, or a capital loss if rates have risen over the same period.
Most bonds are actively traded every day. Active management can result in superior returns for bonds as one trades in and out of short, mid and long bonds as well as differing quality corporate bonds. The probability of achieving greater returns from trading bonds, either individually or in a bond mutual fund, as opposed to a buy and hold approach for GIC’s is much greater as the investor is not restricted to making a onetime only decision in the case of GIC’s. If one buys a bond and subsequently realizes a better opportunity exists elsewhere, most bonds are readily tradable. Bond mutual funds do this automatically for the investor. On the other hand, a GIC investor cannot change their mind as the security is normally not liquid.
Many years ago, the only option for maturing RRSP’s switching into RRIF’s, was to purchase an annuity. If interest rates at the time of purchase were low the retiree was permanently penalized through lower returns for the rest of their lives. These laws were subsequently changed permitting the same investment holdings in a RRIF as in a RRSP without any stipulation to buy an annuity. Thus investing in an annuity is analogous to a term of a GIC as the investor is at the mercy of the level of interest rates at the day of purchase, with no flexibility to switch into a higher yielding investment at a later date.
One final factor to consider is the tax efficiency of bonds and bond mutual funds compared to GIC’s. The capital gain component of bonds and bond mutual funds make them significantly more attractive from an after tax point of view relative to GIC’s, as tax rates for capital gains are one half of the tax applied to interest income.
In summary, bonds and bond mutual funds offer quite different investment opportunities to GIC’s. The ability to make bond switches anytime before maturity, the opportunity to make capital gains if interest rates decline as well as the increased liquidity and the more attractive tax efficiency, offer the bond investor the opportunity to achieve better returns over bank GIC’s.
Peter McMurtry, CFA, July 14, 2011.