Q: I would appreciate it if you could write an article contrasting the advantages and disadvantages of holding bond funds versus GICs. – A.R.
All of my model Couch Potato portfolios include bond funds, and I’m frequently asked whether a ladder of GICs would be a good substitute. In many circumstances the answer is yes. Indeed, our clients at PWL Capital often hold a combination of bond funds and GICs in their portfolios, because these two investments each have strengths and weaknesses. Let’s look at the relative advantages of each.
When GICs are preferable to bond funds
Higher yields. As of March 25, the yield on five-year federal bonds was 0.75%, while you can easily find five-year GICs paying over 2%. Normally higher yield means higher risk, but both federal bonds and GICs are backed by the Government of Canada: GICs up to $100,000 are insured against default by the Canadian Deposit Insurance Corporation.
Tax efficiency. These days just about all bond funds are filled with premium bonds, which are notoriously tax inefficient. Premium bonds pay a lot of taxable interest and then suffer capital losses when they mature. Bonds trading at a discount or at par are a better choice if you need to hold fixed income in a taxable account, but these are hard to find. GICs always trade at par, which makes them a tax-efficient alternative to bond funds. For a full explanation, see Why GICs Beat Bonds in Taxable Accounts.
Price stability. If you hold a bond ETF you’ll watch its price rise and fall daily as interest rates change, and many investors find that stressful. GICs, however, are not priced daily. So if you buy a compound GIC, you’ll watch its value grow steadily with each interest payment and it will never fall in price. This is something of an illusion brought on by the fact that you can’t sell a GIC before maturity: if you could, then its price would also move up and down with changes in interest rates, just like a bond. But many investors still find it comforting to see their fixed income investments move in only one direction.
Predictability. GICs are a great choice for investors who are drawing down their portfolio in retirement. Say you need to draw $30,000 annually from your portfolio to meet your daily expenses. A ladder of GICs, which each one holding $30,000, can provide reliable cash flow for at least five years, regardless of what happens in the stock and bond markets. Bond funds, by contrast, have no maturity date, so their return over any given period cannot be known in advance.
Where bond funds have the edge
Liquidity. The biggest downside of GICs is that they are not liquid: you need to hold them to maturity. Bond funds, by contrast, can be sold at any time. This makes them much more suitable for investors who may need to dip into their investments to meet an unexpected expense, or simply to rebalance their portfolio. Even if a client’s RRSP includes a GIC ladder, we will often include a bond fund as well so we have something to sell if we need to buy more equities when rebalancing.
Availability in any amount. Many brokerages have minimum purchase amounts for GICs, which can range from $1,000 to $5,000, or in more in some cases. Bond funds are available in any amount. Moreover, if you use a bond mutual fund (as opposed to an ETF), you can set up automatic contributions with small amounts every month, something that’s impossible with a GIC.
More portfolio diversification. One of the main reasons to hold bonds in a balanced portfolio is that they can provide safety net when stocks plummet. During a market crash, interest rates typically fall, pushing up the price of bonds funds and offsetting some of the losses. When stocks around the world plummeted in 2011, for example, short-term bonds rose more than 4.5%, cushioning the blow. GICs, meanwhile, would have seen no price appreciation.
Longer maturities. Only GICs with a maturity of five years or less are eligible for CDIC insurance. Bonds are available with longer terms, which increases risk but may also deliver higher returns and more diversification in a balanced portfolio. A broad-based bond fund—such as the Vanguard Canadian Aggregate Bond (VAB)—has an average term of 10 or 11 years, which means it will rise and fall more dramatically than bonds with maturities of five years or less. In 2014, for example, broad-market bond funds returned more than 8% as interest rates fell.