We live in a low-interest rate world. As such, finding the best returns for your money is increasingly important. If you’re not going to make a huge return on your savings, you might as well go for the best deal out there.
And assuming you have money you aren’t comfortable investing in equities, you probably will turn to fixed income investments. These might be GICs, government bonds, and even savings bonds. There are also corporate bonds.
A few weeks ago, The Globe and Mail’s Rob Carrick made the point that investors might want to consider some high-quality corporate bonds over GICs. It’s an intriguing suggestion so let’s take a look at how corporate bonds differ from GICs and why you may or may not want to add them to your portfolio.
For starters, GICs and corporate bonds are both debt instruments that pay a (generally) fixed rate of return. The borrower has a liability to the lenders.
But there are some differences. For one thing, GICs aren’t actively traded, unlike corporate bonds. In theory, a bank could refuse to let you out of a non-redeemable GIC early, although most will let you out and you may simply forgo any accrued interest.
The advantages of corporate bond
Another difference is the potential for capital gains. This doesn’t apply to GICs, but is relevant to corporate bonds. For example, if you buy a company’s bond when it’s yielding 2% and investors bid the price of the bonds up, you could sell it before maturity and record a capital gain.
What might cause the bonds to rise in value? The biggest single factor would be the level of interest rates for comparable bonds. If interest rates are falling, bond investors will flock to existing securities that have a higher yield. This pushes the price up and the yield down.
Finally, you can get a higher return with corporate bonds than with GICs. The difference isn’t huge but you might be able to earn an extra 20 to 30 basis points (100 basis points = 1%) if you buy the right corporate bonds.
The risks with corporate bonds
However, there’s a key difference between GICs and corporate bonds. Namely, corporate bonds aren’t backed by government deposit insurance. In other words, if the issuing company defaults on its liabilities, you may not get all of your money back.
One way to avoid this possibility, Carrick suggests, is to only buy high-quality “investment grade” bonds. These are bonds issued by companies deemed to be very creditworthy by ratings agencies. Investment grade is the opposite of high-yield or “junk” bonds, where the risk of default is seen to be high.
A word of caution is in order, however. Just because a ratings agency deems a bond to be investment grade doesn’t mean the issuer won’t run into trouble in the future. The world of finance is littered with examples of supposedly safe debt securities that ultimately went bust (there were countless AAA-rated bonds in the U.S. subprime meltdown that didn’t live up to their billing). If you’ve seen The Big Short, you’ll understand what I mean.
The bottom line
If you’re buying a fixed-income product, your first aim should be to preserve your capital. Current interest rates aren’t high enough to make a fortune so you really ought to prioritize the safety of your money over a tantalizing yield.
So if you’re thinking of dipping your toes into the world of corporate bonds, you’ll want to do some due diligence and do some research about the company’s health. And remember, as always, inflation isn’t your friend when it comes to fixed income. This is something to always keep in mind if you’re tempted by longer-term investments.
- How to Build a GIC Ladder
- The Role of GICs in an Investment Portfolio
- Saving in a Low-interest Rate Environment
Flickr: Andreas Poike