Comparing GICs and Bonds as Interest Rates Rise
When it comes to investing, the general advice has been to be cautious about putting your money into fixed-income investments in the current market. This is primarily because of the rock-bottom interest rates we previously saw.
However, there are still compelling reasons why you may consider holding interest-bearing vehicles like GICs given current market conditions and rising interest rates. For instance, diversifying your portfolio or seeking lower-risk options as you approach retirement age. Despite the expectation of continued rising interest rates, the demand for fixed-income investments from consumers is likely to persist, making GICs worth exploring as part of your investment.Â
Choosing the right investment within this category has become more challenging in the current fiscal environment, particularly when comparing GICs and bonds. While some may view them as similar, savvy investors recognize the distinctions between the two.Â
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What are GICs and how do they work?
GICs, or Guaranteed Investment Certificates, involve lending an agreed-upon amount of money to a bank, trust company or other financial institution for a specified period at a particular interest rate. While the minimum investment might range from $500 to $1,000, you can invest more if desired. The duration of the investment can vary from as short as 30 days (typically for larger cash amounts) to as long as 10 years.Â
When considering GICs, it's important to shop around as rates can vary significantly between institutions. A key advantage for investors is that GICs are generally guaranteed by the Canada Deposit Insurance Corporation (CDIC), but this guarantee only applies if the GICs are purchased through CDIC member issuers.Â
Therefore, in most cases, the principal amount invested in a GIC is secure, as well as the fixed interest rate. They remain unchanged throughout the investment term.Â
It's important to note that due to the fixed interest rate, your GIC return may not keep pace with inflation. For example, if GIC rates are 5% and the annual inflation rate is 8%, the real purchasing power of your investment will decrease by 3%.Â
Furthermore, GICs are typically not easily redeemable, especially if you have purchased non-redeemable GICs. If you cash them in before maturity, you may face a significant penalty.Â
What are bonds and how do they work?
Bonds are another type of debt instrument that acts like an IOU. When you lend money to a company or the government, they promise to repay you the principal amount with interest.
While some bonds have terms similar to GICs, the duration of bonds can extend into decades. The longer the term, the higher the coupon rate you can expect.
However, bonds, come in a wide range of varieties, including convertible bonds, high-yield bonds, and inflation-indexed bonds. They also carry more risk compared to GICs, both in terms of fluctuating interest rates and the potential for corporate defaults.
Unlike GICs, you have the flexibility to sell your bonds in a secondary market before their maturity date, without any penalties. This allows you to minimize losses by selling bonds that are declining in value and reinvesting in more favourable options. However, selling bonds before maturity can result in a loss on the principal amount.
As interest rates rise, bonds with lower coupon rates tend to decrease in value. This means that the price of the bond, typically expressed as a dollar value above of below $100, may drop. For example, a bond purchased for $100 may only be sold for $95, resulting in a $5 loss per $100 of the bond's value.
Compared to GICs, bonds are less predictable in terms of financial outcomes.Â
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What is a laddering investment strategy?
Investors may also consider employing a laddering strategy with bonds or GICs.Â
Laddering involves dividing your investment into equal amounts and purchasing bonds or GICs with different maturity dates. For example, if you have $50,000, you can invest $10,000 in one-year bonds, $10,000 in two-year bonds, $10,000 in three-year bonds, and so on.
Laddering allows you to maintain a consistent maturity profile and gives you the flexibility to reassess and adjust your investments each year.
When the first $10,000 worth of bonds reach maturity, you take that cash and buy $10,000 in new five-year bonds. You repeat the process as long as you feel comfortable.
The benefits of GICs
Choosing between bonds and GICs depends on an individual’s circumstances and investment goals. While GICs have traditionally been popular among older/more conservative investors, they can be useful for any age, depending on their financial goals and situation. The main advantage of GICs is the certainty of receiving the invested amount plus the attached interest rate within a specific timeframe.
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The benefits of bonds
If you anticipate needing the invested money in the future, bonds with a well-established secondary market may be more suitable. Although there may be some losses upon sale, you have the option to cash out. Additionally, you have the flexibility to explore different types of bonds. Corporate bonds, for instance, can offer higher yields than government issues. However, they come with increased risk due to the potential for corporate bankruptcy. But you’ll get a higher rate of return on your investment.
GICs generally don’t have such flexibility. Finally, bonds offer longer maturity dates ideal for younger investors.
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