The problem with Comparing GICs to Recent Market Returns
For the first time in over a decade GICs (Guaranteed Investment Certificates) are providing investors globally with reasonably attractive interest rates. As central banks across the globe have executed one of the fastest hiking cycles on record, GIC’s are now offering 5%+ on their deposits across a whole array of lock up periods. With 2022 being a very difficult year for most investors, it skewed the past 3 and 5 year annualized returns downwards. Simultaneously, as interest rates have increased, the GIC market rates have also increased. This has left investors questioning why they should invest in markets when the forward looking return on a GIC looks similar or higher than their previous annualized return. While a valid question, there is one major discrepancy to account for when making the decision to invest between a diversified bond portfolio and a GIC.
First, let’s discuss the major differences between the advertised returns of a GIC and a Bond Fund.
GIC’s are a type of fixed-income investment that typically offers a guaranteed rate of return over a specific period of time. When you invest in a GIC, you are agreeing to leave your money with the issuer (usually a bank or financial institution) for a set period of time, and in exchange, you will receive a guaranteed rate of return on your investment. The rate of return on a GIC is typically fixed, meaning that it does not change over the course of the investment term.
Bond funds, on the other hand, are a type of investment that allows investors to pool their money and invest in a diversified portfolio of bonds. Bonds are a type of debt instrument that allow companies, governments and other organizations to borrow money from investors. When you invest in a bond fund, you are essentially lending your money to the organizations that issue the bonds in the fund’s portfolio. Bond funds typically pay regular interest payments to investors, and the value of the fund’s holdings may fluctuate depending on the performance of the underlying bonds.
Now, if you were to read those two paragraphs with no knowledge of financial markets or compliance reporting you would think that a Bond fund and a GIC are very similar vehicles. This assumption would be correct with the absence of one key difference that produces the entire issue when we comparing GIC advertised returns to Bond Funds.
The key difference between GICs and Bond funds is that GICs offer guaranteed returns while bond fund returns are not guaranteed. The return on the bond fund will fluctuate over time depending on both the performance of the bonds in the fund’s portfolio and macro environment interest rate direction. Since GIC returns are guaranteed, the advertised rate that the banks provide are forward looking, meaning that they are to happen over that time frame. With Bond funds, because the returns can and will fluctuate, they are not able to provide forward looking returns, and any return associated with a bond fund is backwards looking.
As interest rates have spent the majority of the last four decades moving downwards, investors haven’t had to contemplate this comparison. Historically speaking, Bond funds have done better than GIC’s as they have benefited from a downward movement in interest rates and, as that downward movement has happened, advertised GIC rates have rarely ever been higher than backwards looking Bond fund returns.
So, how does one compare apples to apples when looking at their Bond fund returns to a 5 year GIC return?
Well, that investor actually needs to go back in time and compare the last 5 years of performance on their Bond fund portfolio to what a 5 year GIC was advertising back in the beginning of 2018. Using data from the Bank of Canada the beginning of 2018, the average Chartered Bank GIC of a 5 year term was 1.60%. Now, in order to attract deposits, most banks will often offer promotional rates that will be higher than that rate. Let’s be aggressive and assume that an investor looking for GICs would have been able to get a rate of 0.5% higher than that over five years bringing our total GIC return over the last 5 years (backwards looking) to 2.1% annualized return. This is a substantial difference in return expectations from the rates we see advertised today. To compare that rate we’ll look at what our core fixed income component, the Kipling Strategic Income Fund, has done over the last 5 years. Net of fees, our Kipling fixed income fund has seen performance on an annualized basis of 3.9%. Even with an aggressive promotional rate being offered for the GIC an investor would’ve experienced an absolute return of 1.8% higher per year by owning the Kipling bond fund versus a GIC.
That brings us to the question of what to do and how to compare the two investment vehicles today.
With GIC rates north of 5% that is a more attractive rate than the backwards looking rate of 3.9%. However, because the overall market environment has changed, we are not expecting a return of 3.9% within our fixed income component on a forward looking basis.
All bonds enjoy what is called a “pull to par” effect as the bonds in a portfolio come close to maturity. If one buys a bond and holds it to maturity, their annual return should be the bonds initial Yield-to-Maturity (YTM), assuming no default. To properly compare a current advertised GIC rate to a specific bond portfolio an investor should be looking at the internal YTM within the bond portfolio as opposed to historical returns in that portfolio. In addition, risk metrics like duration, credit quality, and average maturity length should be accounted for.
With that knowledge let’s now again compare the current GIC environment to our core Kipling Strategic Income Fund. In the current environment, the YTM is 7.80% with a duration of 1.9 years. Although there is no guarantee, as long as there are no major performance issues with the bonds in the fund or continued adverse central bank activity, we would expect this vehicle to continue its historic outperformance against the GIC market.
In the three years since the Covid pandemic there have been vast changes in the investment universe and concepts that investors haven’t had to think about in decades which are, finally, beginning to matter again.
Please reach out to us for a discussion on how your portfolio has adapted in the new regime.