Q1 2022 was the worst quarter for fixed income in four decades as central banks commenced tighter monetary regimes to combat persistently high inflation. In response, bond yields spiked, sending bond prices sharply lower given the classic inverse relationship.
The upside to this challenging scenario is that the upheaval in yields has created an opportunity for fixed income investors to purchase bonds and GICs at the most attractive yield levels in many years. In response to the increase in GIC yields, investors are wondering if they should utilize GICs instead of bonds as a source of safe income. But are they the best option?
This article considers the different roles that bonds and GICs play in a portfolio, along with potential advantages and disadvantages to consider when making an allocation. At this juncture, there are three key reasons why investors should favour bonds over GICs:
- Greater Return Potential
- Tax Efficiency
- Superior Liquidity
The Role of GICs and Bonds in Portfolios
Investors may hold GICs and bonds for a variety of purposes, including:
- A long-term strategic allocation that provides income and stability
- A transitory placeholder that will be invested in higher return-seeking assets in the future
While the use case is often lumped together, it is essential to view these asset classes as distinct. GICs have historically been utilized as a transitory allocation to provide a risk-free level of income while also generally guaranteeing a low or negative real return. The recent market volatility has made investors believe that GICs can be a substitute for bonds over the long term.
However, bonds can play a more robust role in a portfolio. Historically, bonds have provided better total returns due to higher yields, capital appreciation opportunities, and tax efficiencies without sacrificing long-term capital preservation or liquidity.
The table below compares some key attributes to consider when comparing the two:
Bonds Preserve Capital and Provide Better Returns
The chart below illustrates that investors pay significant opportunity costs, especially in the long run, when they are lured into investing in GICs after periods of market volatility
GICs Never Go Down But They Also Never Go Up
One of the main reasons bonds outperform GICs over longer periods such as 3 and 5 years, is that bonds are largely “self-correcting.” As yields go up and prices come down, having the flexibility to capture higher running yields enables investors to retrieve some of that lost capital. GICs’ inherent aversion to mark-to-market risk is alluring, but remember, an investor forgoes the ability to capture higher yields when they lock in the prevailing GIC yield.
In addition, bonds can play an active role in protecting capital when equity markets experience drawdowns. It is easy to get caught up in recency bias and believe that bonds and equities will continue to lose money together as is the case today, but traditionally, this has not been the case.
Canadian equities have lost more than 5% in 14 quarters since 1999. The average quarterly return of Canadian equities, bonds, and GICs during these quarters are:
- S&P/TSX Composite = -12.1%
- FTSE Canada Universe Bond Index = +2.6%
- 3-Year GICs = +0.5%
Overall, bonds tend to provide an inversely correlated return stream to equities and insulate investors' portfolios during times of equity turmoil, while also outpacing the return of GICs.
Discounted Bonds Retain More Yield After Taxes
An important consideration when calculating total returns is the need to adjust for taxes. GIC returns are sourced 100% from coupon payments, which are taxable in non-registered accounts at an investor’s full marginal tax rate.
On the other hand, a bond’s total return consists of both interest/coupon payments and capital appreciation and can be more tax-efficient, particularly when purchased at a discount to its original issue price (usually $100 Par).
To illustrate, we have provided an example of a 3-year GIC vs. a 3-year corporate bond trading at a $5 discount to its original Par value
The yield to maturity for this specific bond is 3.92%, split as ~2.24% per year from coupon payments and the remaining 1.68% from an upward move in the bond price as it gets closer to its maturity date and repayment of principal.
The yield that an investor collects from the non-coupon related increase in the bond price is taxed beneficially as a capital gain and ultimately leads to a better after-tax return for a taxable investor relative to holding a GIC with a similar yield.
Bonds Provide Liquidity at a Reasonable Cost
Bonds are liquid, publicly traded instruments that are generally traded over the counter (OTC) through dealers. Transaction costs are not standardized like they are for equities that are traded on an exchange. Instead, transaction costs are embedded into the dealer's bid-offer spread and typically have a minimal impact on prices for liquid investment-grade bonds.
Non-cashable/non-redeemable GICs are almost always required to be held until maturity. To break a contract early, you would have to demonstrate significant financial hardship, and even then, there is no guarantee that an issuing financial institution would let you redeem. If the issuer does agree to break the contract, there are usually substantial penalties which often include the loss of some or all of your accrued interest.
For clients who prefer higher liquidity, a daily traded mutual fund or monthly redeemable investment fund might be a more agreeable way to pursue higher yields and returns. Particularly if the allocation has a longer strategic role in a broader portfolio setting that has been tuned to achieve pre-defined financial goals.
Putting it All Together
For decades, bonds have been a resilient and consistent asset class that has provided investors with sought-after stability. Although the recent volatility has been unfortunate, it has given bonds the ability to once again offer longer-term protection and a return profile that is now more likely to keep pace with inflation over the next few years.
We believe this is a critical period for investors to move closer to a neutral weight in bonds as the higher forward yields and capital appreciation opportunities can now compensate investors over the intermediate and longer-term. Simple logic would dictate that the time to buy bonds is when inflation measures are above average considering higher yields are available as compensation for that risk, particularly when you have a long investment horizon and the chance of inflation being lower in the next few years is more likely.