Even for seasoned investors, during times of market volatility, there is a tendency for investors to shift their mindset from capital growth to capital preservation.
So, for capital preservation, are bonds or GICs better? Which is better, when?
We’ll unpack that a bit in today’s post and offer our take on how we manage our portfolios, along with insights from clients too!
What are bonds?
We’d like to think of bonds as an “IOU”.
A bond is a certificate you receive for a loan you make to a company or government (an issuer). In return, the issuer of the bond promises to pay you interest at a set rate and to repay the loan on a set date. (Reference).
Bonds are very similar in fact to GICs (Guaranteed Investment Certificates – more on that in a bit), in that governments or financial institutions issue them to raise funds from investors willing to lend in exchange for interest. However, a major difference between the two is that in most cases, bonds are publicly traded, meaning investors have liquidity even if their principal is locked for the bond’s tenure (length of time invested). As a result, bond investors are exposed to capital gains/losses as bond prices are affected by various factors such as equity market performance, the prevailing interest rate, foreign exchange rates, and other economic factors.
We can see this playing out right now. There is lots of talk about bond prices effectively going “nowhere” anytime soon with interest rates rising.
Interest rates reflect the cost of borrowing money. General lending and saving money practices amongst institutions and retail investors alike make the economy go round!
If the economy is growing quickly or if inflation is running hot, then our central bank (Bank of Canada) may increase interest rates. This triggers retail financial institutions to raise the rates at which they lend money, pushing up the cost of borrowing. When this happens, institutions may also raise their deposit rates, which makes the incentive to save money and keep savings intact more attractive for folks like us too.
While any central bank is responsible for setting a country’s short-term rate, they do not and cannot control long-term interest rates. Market forces and broader economic factors are simply too complex and too strong to easily contain. So, market forces determine long-term bond pricing. That’s important to understand since this is where some bonds or bond ETFs might be helpful for you.
Bond prices and interest rates as they relate to GICs
So, we have summarized that bond prices have an inverse relationship with interest rates.
Rates go up, bond prices come down.
Understanding and accepting interest rate risk is generally part of the game when you own bonds.
Bond pros and cons:
1. Liquidity – bonds (bond ETFs in particular) offer investors liquidity as they are publicly traded, you can get your money back without paying hefty redemption penalties less any transaction costs typically.
2. Lending options – you’ll read below that GICs are only issued by financial institutions and government-backed entities (for a reason!), but bonds can be issued by even corporations. So, you have many options – a portfolio of bonds can include different issuers, with different maturities, with different ratings (i.e., quality of the bond issuer subject to default) which can help bond owners increase their returns.
3. Bonds have volatility – we believe bonds are not “as safe” as GICs since they are exposed to capital gains and losses; market factors mentioned above.
There is of course much more to any bond story but this primer is meant to draw a snappy comparison of which is better, when, below!
GICs, by nature of their very name, offer more stability given they are backed up by the Canadian government – so they can be considered a lower-risk, lower-reward fundraising tool.
A GIC is an investment that protects your invested capital. You will not lose money on the investment. GICs can have either a fixed or a variable interest rate. (Reference).
Like bonds, interest rates offered by GICs can vary over different maturities, between institutions, but rates are generally higher over longer periods of investing time.
Guaranteed Investment Certificates (GICs) are considered lower-risk investments because the guaranteed part means you are guaranteed to get back the amount you invest — the principal — when your GIC matures.
Ideally then, you buy a GIC, hold it to maturity, and get your principal back AND interest as well. This is not unlike a saving account: except that your money is locked in to grow for a predetermined period of time. When the investment matures or reaches the end of that time period, you get your money back plus the agreed-upon amount of interest.
As long as you let your GIC mature, you are guaranteed that money. However, if you withdraw the funds earlier than the certificate contract allows, you will be penalized and may lose some or all of the interest.
That said, some GICs are cashable or redeemable, but they typically come with a lower interest rate. Also, if you do need to withdraw your funds, you could end up paying a penalty.
Beyond the nuts and bolts of some GIC products, here are some considerations below.
GIC pros and cons:
1. Safety – while bonds (and bond ETFs in particular) offer investors potentially higher investment returns, because GICs are safer, they tend to deliver lower returns for the risks-taken; based on the guarantees provided. Your GIC is insured if you bought it at 1) any major Canadian bank – banks are members of the Canada Deposit Insurance Corporation (CDIC), or 2) a credit union or Caisse Populaire. (This means you will get your money back if the financial institution where you bought your GIC closes down, defaults or the institution is unable to pay you when the GIC matures. Coverage depends on the value and type of GIC you hold.
2. Inflation risks – because regular GICs have a relatively low expected return, they may not keep pace with inflation. While some market-linked GICs exist (that don’t pay a fixed rate of interest), even then these GIC products may not beat inflation.
Bonds vs. GICs – Which is Better?
Now, the drumroll…bonds vs. GICs – which is better?
We believe bonds can be great for many investors.
The key reasons to own bonds, in our opinion, is as follows:
- Bonds can help your investing behaviour (helping you ride out stock market volatility).
- Bonds can be used to rebalance your portfolio (helping you keep your portfolio aligned to your investing risk tolerance/mix of stocks and bonds – probably one of the biggest reasons to have bonds if you want them).
- Bonds can be used for spending purposes – where some fixed income may be considered “king” for major, upcoming, near-term spending.
We could discuss bonds as a hedge for deflation (since inflation is a killer for bonds long-term) briefly here. When there’s inflation, your bond income is worth less over time, but in a deflationary environment, they’re actually worth more. So, some investors might own bonds as a hedge for any recession.
But recessions are not constant, recessions are not consistent, and recessions simply don’t last.
This makes bonds helpful, generally speaking in our opinion when the markets tank to hold on and/or for rebalancing. That’s about it.
But markets don’t tank all the time, in fact, they tend to go up.
Many investors, dare we say most investors (?), have a hard time with market volatility.
At Cashflows & Portfolios, we’re not immune to that. MAJOR market declines can be gut-wrenching to live through. Owning bonds in your portfolio can help bring the overall portfolio volatility down a few notches through prudent asset allocation. Yet invariably when you own bonds, you are trading away long-term equity returns with it.
If you don’t want to take my word for it, check out this page courtesy of Vanguard when it comes to long-term returns.
At Cashflows & Portfolios, we believe unless one or more of those reasons apply to you for bonds, then GICs and/or cash might be a better bet to always keep.
Why invest in a GIC?
Here are some key reasons as they relate to our readership and clients:
- If you struggle to save. If you have trouble saving or spending your money, GICs can help. Most GICs have early withdrawal penalties. That should make you think twice about taking any money out of any GIC and holding that product to its term maturity.
- If you’re saving for a specific short-term goal. If you’re planning a dream vacation, a wedding, buying a car or any major purchase in the coming 1-2 years, consider putting money into a GIC beyond a high-interest savings account. Yes, you might not earn lots of money via interest but your principal is guaranteed AND you are likely to earn a little bit of interest in the process.
- If you’re retired or will be retired soon – keep a GIC for accessing money soon. This applies to most of our readers and clients. GICs are much less volatile – they are not subject to market forces including capital losses. If you won’t or don’t have any time to let any market-based investment (including a bond) bounce back from lower prices, then consider a GIC. Many clients we have at Cashflows & Portfolios are considering keeping at least 6-months to 1-years’ worth of cash savings as they enter retirement – regardless. That’s the bare minimum for most. Meaning, should the market shut down completely, clients that keep 6-months to 1-years’ worth of cash savings set aside could live off that without touching any assets, selling any stocks, or selling any ETFs – they could live off cash savings for many months without losing sleep. You should consider the same! Beyond some cash, retirees and soon-to-be retirees are also considering a 1-year GIC or even a 1- and 2-year GIC (beyond their predominant equity portfolio) to help navigate market downturn risks. Especially with interest rates moving up!
GICs can be laddered/staggered over time.
As GICs mature, you simply buy more and replenish the ladder:
If you want to reduce interest rate risk, guarantee your principal, AND earn interest – then spreading out your GICs and their maturity dates in a laddered format can be a smart, overall portfolio risk reduction hedge.
You can choose the amount of GICs, duration of GICs are more – all Canada Deposit Insurance Corporation (CDIC) insured.
We believe most retirees, given where interest rates are likely to exist for the coming years (rising, but overall low historically speaking), will benefit the most from:
- Owning far more % of stocks than bonds or cash in their portfolios for growth,
- Owning bonds only for some key reasons above as they relate to risk management, AND
- Owning some cash and/or some GICs beyond cash for a mix of liquidity, safety, and security.
Bonds vs. GICs – Which is Better Summary
At Cashflows & Portfolios, we know some 100% equity investors who keep some cash on the sidelines, as they plan for and/or sustain their retirement income plans.
We know of some investors that have a mix of real estate, business income, dividend income, and more to help fund their retirement.
We know of very few investors that hold lots of bonds, significant amounts of cash, or loads of GICs. In fact, we might not know any!
There is a reason for this!
Growth has historically come from stocks more than bonds and even more than just idle cash. Use that history to your future advantage. Be mindful that bonds have significant market risks. Keeping some money always liquid (cash savings) and/or some money safe (including via GICs) is always smart.
While you might want some bonds in your portfolio to enter retirement with, depending on where interest rates are, GICs might be a better, safer and more dependable fit.
Improve your retirement readiness at a low cost!
Everyone has a different path on their asset accumulation journey – with cash, GICs, bonds, stocks, real estate and more. We know. At Cashflows & Portfolios, even though we both own 7-figure investment portfolios now, we’ve built our respective portfolios similarly but differently. The common denominator on our retirement readiness path is we absolutely keep some cash and hold mostly equities – and we won’t rule out using some GICs as well!
Whether it’s a better understanding of GICs or navigating the alphabet soup of RRSPs/RRIFs, LIRAs/LIFs, CPP, OAS and more – I know we can help you out.
We answer client questions such as:
- What registered accounts do I draw down first?
- How much income will my investments generate?
- Do I have any idea how long this income might last?
- What amount of taxes will my portfolio incur?
- When should I take my workplace pension?
- And much, much more…
Knowing how to demystify the retirement income puzzle is not trivial work but it’s absolutely something we can help with – we’ve helped dozens of clients in the last few months alone!
If you are interested in obtaining private retirement projections for your financial scenario, please contact us here to get started.
Stay tuned for more, great, FREE content on our site. We’re happy to help.