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.
‘More portfolio diversification’ is really just ‘Liquidity’ and ‘Longer Maturities’ in disguise, right? As you point out, your GICs do in fact rise in value when interest rates fall, so the effect on your overall portfolio is the same, except that 1) you can’t immediately sell them, and 2) their duration will only be a few years, so the change won’t be large. Still, a GIC ladder plus a bit of a 5 year bond fund like CLF should perform the same from a diversification perspective as the bond fund alone.
@Nathan: I suppose that’s one way of looking at it. But when I say a GIC rises in value when rates fall, that’s only a theoretical concept. The actual value of the GIC in your brokerage account does not change. So if you were measuring your portfolio’s rate of return year by year, there is definitely a difference between holding a GIC and a five-year laddered bond fund.
Thanks for the article, Dan. By the way, I’m curious about the movements of Canadian bond yields over the last few weeks. It seems they have been moving in lock-step with US Fed bond yields. So when the Fed hikes rates (and assuming the BOC does not, or even cuts rates further), will Canadian bond prices take a hit in response to the Fed? I would think that there should be no relationship between the two. I have a sizable allocation to medium-term Canadian bonds in the belief that a BOC rate hike is far, far away – is my strategy mistaken?
@AR: Rates in Canada and the US should not be expected to move in lockstep over any meaningful period, but US rates will have an influence in Canada. In any case, probably best not to position your bond holdings based on what you think either central bank will do: it’s just guessing.
My savings account at one of the Canadian majors pays 0.85%. To exceed that return even marginally I would have to use one of their GICs with a term greater than two years. Under what set of circumstances would I chose to lock my money into something that offers no meaningful advantage over my current account?
@Jerry: It might make sense to buy a two-year GIC paying about the same as a savings account if you believed that interest rates were going to fall. But if you have no view on the market, I would agree with you. However, it is quite easy to find two-year GICs that pay significantly more than a savings account (1.5% or more).
This web page will help you find high yielding 2 year GICs:
In addition, high interest saving accounts that pay more than 1.5% still exist.
Thanks, this is helpful. Given that interest rates are very low, and that they don’t have much room to go further down, does it make sense to invest heavily in bonds in Canada (or US) in the next 5 to 10 years? And if not, what is the alternative given that GIC barely covers inflation? In short, rather than have 40% in bonds, does it make sense to have 20-30% in bonds, and to have 10-20 elsewhere as a part of a portfolio strategy?
@Hes: Your question is very common, and there’s no easy answer. It might make sense to reduce your allocation to bonds, but only if that decision is in line with your willingness, ability and need to take more risk in your portfolio. In general, in a world where expected returns are lower I don’t think the solution is to take more risk. It may simply be saving more money.
I’d love to see your talk here in Vancouver, hope that’s something in the pipeline.
I want to thank Dan for his talk earlier this evening at the North York Central Library. Although I have been following your work here at CCP for some time, it was great to hear and see you in action. I smiled to myself a few times during the Q&A session noticing many of the questions were already CCP articles and thought “Dan’s got this”; the first question about preferred shares almost made me chuckle.
A big THANK YOU to Dan for his presentation tonight at North York Central Library. Beginners and more experienced attendees alike were able to ask questions freely during the Q&A afterward. Can you please consider more advanced free sessions in the future? Can’t make it out to Oakville unfortunately.
I’m a fan of GIC’s. I’m a saver. I would assume if a person is a great saver and start young they can get away with a lot of GIC’s but if someone is lousy saver and late starting to save they would need to take higher risk to get the same portfolio value when they retire ?
Not trusting a bit this shaky market, and though I’m in my early forties, I chose to invest in the 70 % fixed income (VAB) / 30 % equities ( VCN + VCX ) Couch Potato Portfolio.
But if the biggest problem of the financial system is the catastrophic amont of bad debt going around, how safe am I when the largest part of my savings are in a bond market likely to fall like a set of dominoes ?
How did VAB reacted in the 2008-2009 crisis ? Is it the “least bad” solution ? If Hell breaks loose, and I can’t see how we can avoid it sooner or later, will my boat only be the slowest to reach the bottom ?
I’ve read all the recent comments concerning bonds and I agree with the 20 to 30% approach.
Why invest in bonds when rates are low and hope for a market collapse? Even thou the Dow wiped out all gains for 2015 in June it is still even and poised to grow. Actually, I’m going to reinvest my 20 to 30% fixed income in ladder GICs. Let’s see how this turns outs …..
I have read a lot about using a GIC ladder for your fixed income (or at least a good part of it). As a retirement vehicle, would it make sense to buy monthly GIC and use that money for your expenses or a once-a-year annual GIC? In other words, if my spouse and I require $48,000 (after taxes) for our annual expenses in retirement, should I just buy a GIC that will mature in January and use that money all year long; or is it easier/same to buy a GIC that matures each month of the year (12 in total)?
I have a 40/60 fairly large portfolio, all fixed income won’t fit into RRSP & TFSA where I’m using Bond Etfs for my fixed income. I like to stay under CDIC limits and try to get what I consider at least reasonable rates for GICs. I have a maxed 5 year GIC ladder at Oaken which I will keep. I’m looking for ways to simplify portfolio and still get reasonable fixed income returns.
1) After tax how much would I lose by holding VAB in non registered compared to five year rolling GIC’s? I need multiple institutions to stay under CDIC and get resoanable rates. That’s the study/comparison I would really like to see? If its less the 25 bp the convenience and monthly pay of VAB may be a good trade off although the income is not required, CIFP limits would be a problem.
2) Would it help the tax bite if VAB was held as part of VCNS (the way fees are structured within ETFs)
3) I’ve heard rumours of CDIC increased limit?
A South Delta Share Club Member retired from work.
@Brian: If you’re considering fixed income in a non-resgietred account and you are running out of GIC options, at least look for a tax-efficient bond ETF. Funds such as VAB and its competitors are paying coupons that are significantly higher than their yield to maturity: right now VAB’s coupon is 3.3% (fully taxable) and the yield to maturity is 2.6%. That’s a bad combination. Compare this to the BMO Discount Bond ETF (ZDB), which has a similar yield to maturity and a coupon of barely 2%.
The yield to maturity of a broad-market bond fund like VAB is likely to be similar to that of a five-year GIC ladder on a pre-tax basis, but that’s not a perfect comparison because the bond fund includes much more term risk (average term about 10 years for VAB) and significant volatility.
If you have a brokerage account with one of the big banks you should be able to access multiple GICs issuers so you can stay within CDIC limits without opening accounts at several institutions.
Whether VAB is held alone or via VCNS makes no different to its tax treatment.
I have not heard anything about CDIC limits being increased, although this would be welcome.
“Whether VAB is held alone or via VCNS makes no different to its tax treatment.”
I think it makes a difference expenses of the ETF are deducted from the distributions starting with fixed income first within a ETF(from your link above) just not sure how much of a difference?
Shouldn’t you use average duration for comparism? 7.6 years.
ZDB is not broad market etf it’s a subset if I’m going couch potato I would like broad market? This I guess is the best available?
Brokerage accounts have pretty lousy Gics rates. In what name are GICs held within a brokerage account? If they are in street name will CDIC apply?