If ever there were a contest held for “Canada’s Most Boring Investment Ever,” I’ll bet that bond ETFs and guaranteed investment certificates (GICs) would duke it out in the final round. We buy them to offset our more glamorous (and more risky) stock funds with some sensible dependability. Then, thankless crowd that we are, we cringe at their related paltry returns.
So in the boring battle between them, which should you use? Laugh at the humble GIC if you must, but even though they’ve been around before many of you were born, GICs may just help save the day in today’s fixed income markets … and will probably outlive you while they’re at it.
Consider this. Between September 30, 2016 and September 29, 2017, the 10-year Government of Canada benchmark bond yield rose from 1% to 2.1%. As the yield increased, prices dropped; Canadian bonds suffered their worst 1-year performance in over 20 years, losing nearly 3% of their value.
Now, relative to the gut-wrenching double-digit drops we periodically see in the stock markets (50% during the last severe bear market), 3% doesn’t sound so bad. But many index investors just can’t stomach seeing their “safe” bond ETF holdings show up in bright red when they view their accounts. If fixed income is going to be so boring, they reason, the least it can do is keep its head above water.
If this sounds like you, GICs may be worth a second look.
Bond ETFs vs. GICs
With a bond ETF, the best estimate we have of its future return is its weighted average yield-to-maturity (YTM). These days, the YTM on Canadian bond ETFs is about 2.34% (see image below). At 10.28 years, the weighted average maturity of the underlying bonds is also higher than you may prefer. This seems like a long time to expose your cash to a little more risk, while receiving so little extra in return.
Enter the good old GIC. Not only does the Canada Deposit Insurance Corporation (CDIC) insure GICs within specified limits, many GICs have yields that rival those of your favourite bond ETFs, with a much lower average maturity. In fact, a 1–5 year GIC ladder at RBC Direct Investing currently boasts an identical average yield of 2.34%, with an average maturity of just 3 years (see image below).
So with the GIC ladder, you could currently get the same expected return with far less term risk.
Portfolio Characteristics of the iShares Core Canadian Universe Bond Index ETF (XBB)
Source: BlackRock Canada as of December 7, 2017
Top GIC Rates: RBC Direct Investing
Source: RBC Direct Investing as of December 8, 2017
Striking a balance
The downside of GICs is that you generally can’t sell or liquidate them until they’re due. This can be an issue if you are trying to rebalance your portfolio back to its target asset mix after your equities tank.
You can mitigate this liquidity risk by holding a combination of GICs and bond ETFs. As a rule of thumb, I tend to hold enough of the portfolio in bond ETFs to be able to rebalance back to my target asset mix even if there’s a 50% stock market meltdown. This rule is a bit confusing, so my cheat sheet below provides the suggested portfolio allocation between liquid bond ETFs and illiquid GICs.
|Model ETF Portfolio||Portfolio Allocation |
to Bond ETFs (%)
to 1–5 Year Laddered
|20% stocks / 80% bonds||8.0%||72.0%|
|30% stocks / 70% bonds||10.5%||59.5%|
|40% stocks / 60% bonds||12.0%||48.0%|
|50% stocks / 50% bonds||12.5%||37.5%|
|60% stocks / 40% bonds||12.0%||28.0%|
|70% stocks / 30% bonds||10.5%||19.5%|
|80% stocks / 20% bonds||8.0%||12.0%|
Let’s work through an example together, adapting my model ETF portfolios to include GICs. Suppose you have a $100,000 portfolio, with a target asset mix of 60% equities and 40% fixed income. (So you would initially have $60,000 in equities and $40,000 in fixed income.) If your equities dropped by 50%, they would be worth $30,000 while your fixed income would still be at $40,000, for a total portfolio value of $70,000. To rebalance the portfolio back to its 60/40 target asset mix, you would need to sell $12,000 of bonds and purchase $12,000 of equities ($70,000 new portfolio value × 60% target equity asset mix = $42,000 minus $30,000 of existing equities = $12,000 of additional equities required).
So for an initial portfolio value of $100,000, you would allocate $12,000 to bond ETFs (or 12%); the remaining $28,000 (or 28%) could be invested in GICs, with $5,600, or 5.6%, invested in each GIC rung.
Example: Portfolio rebalancing using GICs and bond ETFs
|Security||Before the 50% stock market downturn||After the 50% stock market downturn |
|After the 50% stock market downturn
|Total Portfolio Value||$100,000||$70,000||$70,000|
|BMO Aggregate Bond Index ETF (ZAG)||$12,000||$12,000||$0|
|Vanguard FTSE Canada All Cap Index ETF (VCN)||$20,000||$10,000||$14,000|
|iShares Core (XUU)||$20,000||$10,000||$14,000|
|iShares Core MSCI EAFE IMI Index ETF (XEF)||$15,000||$7,500||$10,500|
|iShares Core MSCI Emerging Markets IMI Index ETF (XEC)||$5,000||$2,500||$3,500|
This illustration also happens to facilitate another important point about the fixed income holdings we so often love to hate. When stock markets do periodically plummet, those “boring” bonds or GICs can suddenly become your best friends. Imagine if your $100,000 portfolio were all-equity, and had plummeted to $50,000 instead of $70,000. You’d probably rue the day you ruled out tempering your stock market risks with some sturdier (if less stellar) GICs or bonds.
So, will you opt for simpler, single bond ETFs, or mix in some GICs as well? Let me know what you think. Either way, in markets fair and foul, give your fixed income investments a little more love. They’ve earned it.