Over the past few years, substantial rate hikes led investors to favour GICs, which, during that period, served as a transitional asset allocation, offering a stable return against the backdrop of volatile bond valuations. Now, however, as global central
banks have begun cutting rates, the opportunity cost of choosing GICs over short-dated bonds has increased.
The falling interest rate environment, combined with changes in Canadian taxation, has made bonds a relatively better investment than GICs. In light of these changes, we believe investors must reconsider their asset allocation strategy.
As GICs mature and investors are faced with lower rates and higher taxes, there are three key factors that underscore asset allocation decisions: return potential, tax efficiency, and liquidity.
1. Active Bond Strategies Have Better Return Potential Than GICs
Over the past 40 years, bond returns have exceeded those of one-year GICs in 29 out of 40 years; in other words, almost 75% of the time. Notably, the few years of bond underperformance versus GICs occurred during years of rising interest rates. Now, as
central banks have begun cutting rates and signaling more rate cuts ahead, the risk of further rate-induced bond underperformance has diminished significantly. In fact, in the years following rate hiking cycles, bond returns have recovered nicely – more
specifically, in 1995, 2000, and 2014, when the US Aggregate Bond Index generated more than twice the return as one-year GICs.
2. Bonds Have Tax Efficiencies for Non-Registered Accounts
GIC returns are derived entirely from income payments, which are fully taxed at the investor’s marginal income tax rate in non-registered accounts. On the other hand, the total returns for corporate bonds may encompass both coupon payments (taxed
as income) and capital appreciation (taxed favourably as capital gains). As an example, the RP Yield Advantage portfolio strategically focuses on high-quality discounted corporate bonds, with a significant amount of the fund’s total expected
return coming from capital appreciation when these bonds are “pulled to par.”
The sample comparison below illustrates the relative tax efficiency of an active bond strategy like RP Yield Advantage compared to a GIC with a similar term.
3. Bonds Offer Liquidity Without Penalty Unlike GICs
Locked-in GICs have significant penalties for early withdrawal, whereas, with an actively managed corporate bond fund, you can access your money within days of redeeming. Given the mixed macroeconomic data, geopolitical tensions, and looming election
risks, markets will likely continue to be riddled with uncertainty. Investors may benefit from being able to quickly and opportunistically rebalance their portfolios using the funding from bond allocations, which would be difficult if the capital
is locked up in non-redeemable GICs. An active corporate bond strategy can allow investors the flexibility to change their minds without penalty.
In Closing
Investors often exhibit a cognitive bias known as “recency bias,” which involves basing future expected performance on recent performance, whether positive or negative. In this context, investors may have experienced negative returns in bonds
and expect the recent relative attractiveness of GICs to persist. However, the tide has turned; central banks have begun cutting rates, and bond strategies are once again outperforming GICs. Historically, falling rates have proven to be fertile ground
for active managers to generate strong returns and offset many of the risks GICs are prone to in such an environment. As the Fed is expected to cut rates over the remainder of 2024, we believe the coming months will offer attractive opportunities
for our team to execute and generate strong risk-adjusted returns.