Bonds, GICs and the Yield Illusion

If you like to keep the fixed-income side of your portfolio as safe as possible, there’s lots to like about the Claymore 1-5 Year Laddered Government Bond ETF (CLF). It carries one of the lowest management fees of any ETF in Canada at a paltry 0.15%. Its default risk is essentially zero, and its short duration means it’s not too vulnerable to rising interest rates. Finally, the ETF uses a laddered structure to spread out interest-rate risk.

However, for many income-hungry investors, the most attractive thing about CLF these days is its 4.5% yield. Indeed, Gordon Pape recommended CLF last month in a Moneyville article, arguing that it was far superior to the “negligible” returns from GICs. Unfortunately, this a classic example of how investors — and commentators who should know better — too often focus on yield while ignoring total return. In fact, CLF is not likely to outperform a comparable ladder of GICs in the foreseeable future. It may well do worse.

Here’s why yield can be an illusion. The bonds held by CLF all have fairly high coupons (ranging from 4.25% to 6.10%), so they throw off a nice stream of income, which gets paid out to the fund’s investors every month. However, all of the bonds in the portfolio were purchased at a premium. Each time one matures — or is sold before maturity — the ETF will suffer a small capital loss. I can attest to this personally: I’ve owned CLF since May 2009, and since that time its value has fallen about 2.8%.

When you invest in a bond or a bond ETF, ignore its current yield and consider its yield to maturity (YTM), which is usually easy to find on the fund’s website. The YTM takes into account both the coupon and the capital loss (or gain) that will occur when the bonds mature. (I explained this idea in detail in a previous post, The Bond Dilemma.) The yield to maturity of CLF is barely 2% — which means that investors who think they’ll be earning 4.5% are fooling themselves.

GICs: What they yield is what you get

Unlike government bonds, which are frequently traded, GICs have no secondary market: you can’t sell yours to someone else. In most cases, you can’t even cash them in before maturity without significant penalty. Their market value never changes, so there is no risk of capital loss, nor any potential for capital gain. The current yield on a GIC, therefore, is the same as its YTM.

With that in mind, here’s what you’d earn from GIC ladders purchased through ING Direct, Ally and Outlook Financial, a Manitoba credit union that’s currently offering the best rates in the country:

ING Direct Ally Outlook
One year 1.75% 1.75% 2.25%
Two years 2.20% 2.40% 2.60%
Three years 2.25% 2.60% 3.10%
Four years 2.30% 2.90% 3.25%
Five years 2.75% 3.30% 3.50%
Weighted YTM 2.25% 2.59% 2.94%

As this table shows, you can get a return close to 3% in the first year from the Outlook GICs. That isn’t “negligible.” On the contrary, all three GIC ladders offer rates significantly higher than the yield to maturity of CLF. And unlike the returns of a bond fund, these returns are guaranteed.

Yield is wonderful, but it’s only half the story. The other half is that there’s still no free lunch.

34 Responses to Bonds, GICs and the Yield Illusion

  1. Jack November 22, 2010 at 10:06 am #

    Hi Dan,

    If a GIC 5 year ladder is better than CLF; is it the potential capital loss at maturity of each “rung” of CLF that prevents you from switching over to a GIC ladder or something else?

    Thank again,
    Jack

  2. Canadian Couch Potato November 22, 2010 at 10:21 am #

    @Jack: I don’t necessarily think that GICs are better than a fund like CLF, only that the two are far more similar than people think. It’s not about 4.5% versus “negligible,” as Pape wrote. It’s about two investments with similar risks both returning between 2% and 3%. For that reason, I don’t see any burning need to liquidate my CLF position, open a new RRSP account with Ally, transfer the funds and build a GIC ladder for what amounts to less than 15% of my portfolio. If I were starting from scratch, though, I would certainly consider it.

  3. DM November 22, 2010 at 10:46 am #

    Thanks for the article, Dan. I think a lot of investors might ignore GICs because they are relatively illiquid. As you mention, if you get into a jam and need to generate some cash quickly, you can’t sell your GIC on an exchange. However, I really like GICs as part of the fixed income component of my retirement portfolio. I hold them in my and my wife’s RSP. I’ve always found that their yields (meaning YTM!) are slightly favourable to bonds of a comparable time frame for the simple reason that the issuer needs to compensate the buyer for the GIC’s lack of liquidity. The fact that GICs are exactly that – guaranteed- also adds to their attractiveness. They will never drop below book value.

  4. Sandy November 22, 2010 at 12:25 pm #

    I am so glad I built my GIC ladder when 5 year rates were b/w 5-5.5% but I am going to be in a pickle next year when one of them matures. I think I’ll just keep it in CLF or XSB until rates go up.

    3% is barely better than a current savings account. Not worth locking up for 5 years. Besides I demand extra for the “lock-up” and once a year payment/compounded.

  5. Paul November 22, 2010 at 3:50 pm #

    Wow, excellent post. I was very seriously considering adding some CLF or CBO to my portfolio (using up precious TFSA room, to boot), and now will reconsider, knowing all the facts.

    Now that I’ve figured out the basics, it’s exactly for this type of post that I read your blog. Thanks !

  6. JR November 22, 2010 at 7:19 pm #

    Another good article telling the whole story of a particular investment. Thankyou
    DM
    I am not sure about Ally or ING . At Outlook, GICs are redeemable if you are in a jam. This would be for a rate lower than the locked in rate, but it is nice to know you have the liquidity.

  7. JayRoc November 22, 2010 at 7:55 pm #

    Great post CCP! I had no idea that the “yield” on these ETF’s weren’t actually the true yields. Thanks.

  8. Fariss November 22, 2010 at 11:12 pm #

    How safe is Outlook? It’s not CDIC. You trust Manitoba Trusts or whatever it’s called?

  9. NorthernRaven November 22, 2010 at 11:27 pm #

    The new Manitoba credit union offering (Hubert/happysavings.ca) has an extra tick on their 2-year rate (2.70%), but it looks like they didn’t match Outlook on the longer terms. You can get 3.60% on 5-year at MAXA (another Manitoba CU).

    Ally pays 1.5% even if you cash out early; Outlook does 1%, and Hubert 1.75% after 1 year. There are also a couple of interesting features on specific Ally GICs. For the one-year, you can cash it in without penalty. For the two-year, you can bump the rate to whatever the current 2-year rate happens to be, once during the term. Note that ING/Ally are CDIC-insured federal banks, while the others are covered by the Manitoba Credit Union Deposit Guarantee Corporation, if it makes a difference to you.

    I’m in the middle of redoing my portfolio and was scheduled to by a big slug of a short bond fund (XSB), but I may defer at least part of it, park at 2 year rates, and punt the decision down the road.

  10. NorthernRaven November 23, 2010 at 1:39 am #

    @DM – with GICs in the RRSP, isn’t it hard to rate shop or avoid getting locked in? ING has no transfer-out fee, but a lot of banks do.

    There’s a spreadsheet available of return rates for various asset classes (http://libra-investments.com/Total%20returns.xls), and I took this and compared it to the returns from an ING savings account (they post their historical rates back to 2000). Short bonds beat that in all years except 2005 . Unfortunately, their GIC rates only go back to 2007, so it wouldn’t be as easy to calculate returns on 5-year GIC ladders. But it seems strange that your GICs would consistently out-return bonds, which should have a premium for the volatility and risk?

  11. NorthernRaven November 23, 2010 at 2:31 am #

    @Fariss – I can’t speak for Dan, but I’m personally agnostic on the Manitoba guarantee issue right now. I did find out that they have not had to pay out from the fund in the last 20 years. I wouldn’t be too worried about any particular institution going wonky – they should be able to clean that up much like CDIC would. The only hypothetical concern I might have is if the whole Manitoba financial sector went kablooey – the Manitoba government might be a bit less likely/able to step in than the Canadian government in a major meltdown of CDIC banks. But I’d think that is a fairly remote scenario, unless the folks in Gimli are related to the bankers back in Iceland… :) I’m actually more curious as to why it is only Manitoba credit unions that seem to be in the top bracket of high-interest products, and none from other provinces.

  12. ETF thinkin' November 23, 2010 at 8:33 am #

    Whoa. That’s a great topic CCP. Thanks for posting it, the information will definately help us out. YTM, never looked at that before, now I will.

    A 5 year laddered GIC is something I have looked at before and in hindsight wish I did in 2007 but I didn’t expect the CDN Gov’t to crash the prime rate either. I would not lock in to a 2+ year GIC as I am thinkin’ the CDN Gov’t will again begin raising rates early 2011.

    BTW – I would trust the Manitoba Credit Union with the 100% guarantee vs $100K for CDIC (too low IMO).

  13. ETF thinkin' November 23, 2010 at 8:47 am #

    Just wanted to test this YTM out and selected the XSB short term bond ETF

    http://ca.ishares.com/product_info/fund/overview/XSB.htm

    I couldn’t find any mention of YTM or “Yield to Maturity” listed… could YTM also be called “Weighted Average Coupon (%)”?

  14. Canadian Couch Potato November 23, 2010 at 11:37 am #

    @Thinkin': “Weighted Average Coupon” is actually the deceptive measure that you want to ignore.

    It looks like iShares doesn’t list the YTM on its site, though Claymore and BMO both do. For BMO ETFs, you have to click on the “Holdings” tab and scroll down to the bottom. For the BMO Short Federal Bond Index ETF (ZFS), the average coupon is 3.33%, while the YTM is 1.9%. The average coupon for XSB is 3.76%, but the YTM is likely to also be in the neighborhood of 2%. You can probably expect slightly higher returns from XSB because it also contains corporate bonds, while CLF and ZFS hold only government issues.

  15. Canadian Couch Potato November 23, 2010 at 12:40 pm #

    Just spoke with the folks at iShares. Their newly redesigned website does not currently include the YTM figures for their bond ETFs, but they are planning to change this soon. In the meantime, here they are, as of November 19:

    XSB 2.14%
    XBB 3.06%
    XRB 1.26%
    XLB 4.31%
    XCB 3.71%
    XGB 2.80%
    XHB 5.29%

  16. ETF thinkin' November 23, 2010 at 3:41 pm #

    Thanks CCP, you have gone above and beyond.

    You would think YTM is quite important to the adverage investor…but yet (to me and as you illustrate), it seems “hidden” or hard to find unless you really know how to dig for it.

  17. ETF thinkin' November 24, 2010 at 8:30 am #

    Sorry to ask 1 more question, but I felt it would be of interest to others on here as well.

    When you look at a laddered GIC vs a ETF Bond fund for returns, would not the ETF Bond fund income get a better tax break than the GIC income?

    Are not ETFs taxed as “dividends” and not “income” like GICs? If so, a GIC ladder doesn’t look as attractive…?

  18. Canadian Couch Potato November 24, 2010 at 9:34 am #

    @Thinkin': No, bond ETFs pay interest, not dividends, and those distributions are taxed at your full marginal rate, just like interest from GICs.

  19. Flagen November 26, 2010 at 4:24 pm #

    @CCP and Northern Raven

    I’ve been looking closely at this too as we move our finances from an advisor to DIY and from mutual funds to etfs.

    There is a reasonable chance, if I understand correctly, that cash will beat short bonds (at least government ones and maybe high quality corporate ones too) moving forward from very low interest rates. There has been a 40 year period in the past when this was the case. If I understand correctly, the faster rates rise, the more likely this scenario would be.

    I really liked a white paper by Ben Inker of GMO (http://www.gmo.com/America/MyHome/default) called Back to Basics, written a short time ago. He goes through the case for his bond conclusion: ” it would be dangerous to rely too heavily on a risk premium on bonds going forward.” I would appreciate your thoughts on his analysis.

  20. Flagen November 26, 2010 at 4:29 pm #

    And if you want to both laugh and cry alot, read also Jeremy Granthams musings in “Night of the Living Fed,” on the same webpage. He is the one voice that William Bernstein says is worth listening to.

  21. Cameron November 26, 2010 at 5:06 pm #

    Looking to invest over a 5 year period into very low risk investment. Was thinking of GIC’s but looking for the “best” rate. Is it assumed that ING and Ally have the best going rates? It seems this way from the posts I have read.
    This website has been god send to some as clueless as me. I really appreciate all the posts to as I have learned so much from them too(TD e-series for example).
    Thanks again.

  22. Canadian Couch Potato November 26, 2010 at 5:26 pm #

    @Cameron: Glad you’re enjoying the blog. ING and Ally certainly have better GIC rates than the banks and are very convenient, but the best rates of all, for some reason, come from Manitoba credit unions. They’re available online to all Canadians. These are all guaranteed, though by a provincial insurance plan, not by CDIC.

    Here’s a great link with current rates:
    http://money.canoe.ca/rates/gics_5.html

  23. Value Indexer December 1, 2010 at 9:42 am #

    Very interesting post – I’ve been starting to collect better information for all the indexes I’m invested in and it turns out that the official website for the DEX Universe index (which I use because I have TD e-Series funds) reports the “yield” when they actually mean YTM. I get it at http://www.canadianbondindices.com/ubi.asp (click on the graph icon on the right side). I’m not sure if the site actually mentions the average coupon; they do a good job of informing investors!

  24. jorden December 4, 2010 at 8:54 am #

    Would it not be safer and cheaper to build a bond ladder by your self. I know this is an option with tdwaterhouse. Or am I way off base?

  25. Canadian Couch Potato December 4, 2010 at 9:08 am #

    @jorden: Building a government bond ladder is just as safe as using GICs, though not necessarily cheaper, as brokerages charge fees for each bond purchase.

  26. jorden December 4, 2010 at 9:16 am #

    Thanks for the quick reply, i figured there would be a fee, so i asked td and they stated the following, “there are no separate fees when purchasing bonds. The cost is build into the spreads.” which i am guessing means they take theirs before they post the rate, is that correct?

    Thanks again

  27. Canadian Couch Potato December 4, 2010 at 9:27 am #

    @jorden: Yes, the yield you see posted will take the fee into account. (This is true of GICs, too, of course.) Are you finding that the yields of government bonds are about the same as GICs with the same maturity? My guess is that the GICs are paying more.

  28. jorden December 4, 2010 at 9:19 pm #

    “Are you finding that the yields of government bonds are about the same as GICs with the same maturity?”

    I built a 1 -5 year ladder with the highest yielding bonds in the TDwaterhouse fixed income section (50% private sector and 50% government) and the Average Yield to Maturity was 2.10383. The TD 5 year “Stepper” GIC yield to maturity is 2.297%. So you are correct, GIC’s are paying more with less risk.

  29. ETF thinkin' December 6, 2010 at 6:45 am #

    I just wanted to add that GIC rates are negotiable based on how much money you put into them as well. For example, a $10k GIC will give you X rate, while a $500k, $1m GIC you can get a higher rate.

    I’m not sure if you had $500k-$1m in a ETF fund would they give you a better rate vs $50k in the same fund.

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