Why Hold Bonds When GICs Yield More Than 5%?

The speed at which interest rates rose took many by surprise. From almost zero in 2020, the key rate of central banks has risen to more than 5% today. This increase impacts other interest rates - from your savings account to your mortgage as well as government and corporate bonds.

Such an increase is bad news for borrowers - including households who must renew their mortgage at a rate of nearly 7% and governments who see debt service literally explode.

An investor's meat is a borrower's poison

The news is better for investors, who can now get a rate of 5.30% on a bank guaranteed investment certificate (GIC). This is higher than the current inflation rate, which we haven't seen for a while. In fact, the rate on GICs maturing in one year is higher than the yield to maturity on a diversified portfolio of Canadian bonds, which is approximately 4.95%.

So, should we buy GICs instead than bonds?

Each has its role

Even though they are both fixed-income securities - i.e., they pay a fixed amount of interest until maturity GICs cannot be substituted for bonds in a portfolio. It would be like hiring an electrician when you need a plumber!

To fully understand the role that GICs and bonds can play in a financial plan, we must first explain their respective characteristics.

GICs

As its name suggests, a bank GIC is an investment guaranteed by the bank that issues it. When you buy a GIC, you lend money to the bank for a fixed term (generally 1 to 5 years), at a fixed rate. GICs cannot be redeemed before maturity¹. At maturity, you receive the accrued interest and the capital is repaid. Additionally, GICs are covered by the Canada Deposit Insurance Corporation (CDIC).

GICs are an excellent tool when your investment horizon is short (less than 3 or 5 years) and capital protection is essential. Are you planning to buy a car next year or make a down payment on a house in 2-3 years? The GIC is the perfect product for you.

If your investment horizon is longer, especially when saving for retirement,you should favor bonds. Let's see why.

Bonds

Bonds are also a form of loan from the investor to the issuer. Governments (federal and provincial) and companies (including the major Canadian banks) issue bonds to finance their activities. Bonds are issued for maturities ranging from 1 year to over 30 years. As with GICs, the bond issuer pays the holder a fixed interest rate (the coupon, generally paid semi-annually) and the principal is repaid at maturity. Unlike GICs, however, bonds are negotiable, meaning you can sell them at any time to access your money. They are therefore "liquid". They are not covered by CDIC.

Their longer maturity and liquidity give bonds advantages that GICs do not have.

Like GICs, they stabilize the value of the portfolio, since their returns are generally uncorrelated with stocks. Additionally, however, bonds provide protection against economic downturns and crisis - which are typically accompanied by falling stock prices and interest rates - since their value increases when interest rates fall.

Bonds protect the value of the portfolio in times of crisis

For example, if there is a recession in 2024 and the yield to maturity on 10-year bonds falls from its current level of around 5% to 3%, the value of the bond portfolio could increase by up to 13%, in addition to the interest payments. A GIC does not offer such protection, because it not cashable and its term is too short². If interest rates go down,it does not increase in value and we must renewe it at the new rate of 3%.

This was also the case during the 2008 financial crisis. From May 2008 to March 2009, a diversified equity portfolio lost almost 45% of its value, while a portfolio invested 60% in equities and 40% in bonds fell by "only" 26%. Of course, both portfolios recovered their value. The 100% equities portfolio has historically generated 2% more annually than the 60-40, but few people can tolerate a 45% drop in their portfolio's value without reacting. Many take the worst possible decision and sell their shares at the bottom of the wave. As a result, they underperform the 60-40 - not to mention all the sleepless nights...

It's a question of objectives

The table below provides a summary of the characteristics of GICs and bonds. Both have a role to play in managing your finances. The GIC is used to manage the cash that you will need in the short term. Bonds, on the other hand, serve to balance your investment portfolio and protect your capital when the stock market declines.

When in doubt, talk to your advisor!

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[1] Cashable GICs can be purchased at any time at a rate of approximately 3%.

[2] You can buy a GIC with a term of up to 5 years if you agree to have no access to capital until maturity.

[3] Some bonds are issued with longer maturities, or even perpetual bonds.

[4] GIC maturity 1 year Bank of Montreal; bond maturity 5 years Bank of Montreal; dated October 25, 2023.