The problem with comparing GICs to fixed income funds
For the first time in over a decade, Guaranteed Investment Certificates (GICs) are offering reasonably attractive interest rates or yields. As central banks across the globe have executed one of the fastest interest rate hikes on record last year, which will likely continue into this year, some GICs now offer 4-5% or more, but with a number of constraints.
With 2022 being a difficult year for investors and GIC rates relatively high, you might be wondering about the benefits of investing in a fixed income strategy through traditional fixed income markets. After all, the return on a GIC may now look similar to or higher than recent investment returns on your fixed income fund or strategy.
While this is a valid question, we believe there are very good reasons to invest in the fixed income or bond markets. Let’s start by comparing GICs to fixed income funds.
GICs and fixed income funds have some things in common
GICs 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 without being able to redeem your money before the maturity date, and in exchange, you receive a guaranteed rate of return that is interest and taxed on account of income. The rate is typically fixed, meaning that it does not change over the course of the investment term and there is little risk of losing your capital. If interest rates fall, you will have locked in an attractive rate, but upon maturity, you may only have lower rates to look forward to. If rates rise, you will have locked-in a lower rate than what’s readily available, although you can switch into a higher rate at maturity. It is also noteworthy that GICs are often alternatives to short-term cash investments though mid and longer term GICs resemble fixed income investments.
Fixed income funds, on the other hand, allow investors to pool their money and invest in a diversified portfolio of bonds that offer a combination of higher yields to maturity and capital appreciation, potentially. Bonds are a type of debt instrument that allows governments and companies, among other organizations, to borrow money from investors for short-, mid- and long-term maturities across the interest rate spectrum. When you invest in a fixed income fund, you are essentially lending your money to a variety of counterparties. The portfolio can also contain an allocation to preferred shares, which pay tax-effective dividends, and other investments known as alternatives that provide extra yield and greater potential total returns.
An experienced fixed income manager will ensure that the portfolio is well diversified to mitigate downside risk and will actively manage the term and credit risk exposures to obtain best returns for the risks taken. As interest rates move up and down, opportunities to lock in capital gains or sell to protect against future losses are available. Fixed income funds typically provide regular distributions composed of coupon interest payments, tax-effective dividends and capital gains, though the fund’s value will fluctuate depending on the performance of its underlying securities.
Reading these two paragraphs, you might notice some similarities between GICs and fixed income funds, but there is still more to the story.
They also have a big difference
To sum these up, GICs offer guaranteed returns based solely on the interest earned on the GIC by its maturity, while fixed income funds provide broader opportunities for a range of investments offering both income / yields and total returns. This means that GICs can advertise forward-looking returns, which is the interest they promise to pay you in the future. In contrast, fixed income funds can only be viewed in terms of backwards-looking returns, which is the actual return they generated over a past period of time consisting of the interest and dividend income plus any realized capital gains or losses relative to the price at which the bonds were purchased.
Because interest rates have spent the majority of the last three+ decades moving downwards until recently, and this has caused the prices of bond prices to rise, fixed income funds have tended to do much better than GICs, which as we described, don’t provide any appreciation potential on the principal amount of your capital. Historically, over long periods of time, forward-looking GIC rates have generally not been better than backwards-looking fixed income fund returns.
So with rates higher now – how does the picture look?
The real question investors are pondering is whether a fixed income fund is still likely to have an edge given today’s higher rates? We believe the answer is yes. This is primarily because the same market dynamics that have led to higher GIC rates can enable us to buy bonds, among other fixed income securities, with higher interest rates or yields and increased return potential.
As described earlier, fixed income funds have a few other advantages to keep in mind. If interest rates rise further, the fund can benefit by buying bonds with ever-higher interest rates within its portfolio of securities. If interest rates fall, the fund’s fixed income securities will appreciate and capital gains may be taken along the way.
A fund can also benefit from bonds that are currently priced below their maturity value as they become more valuable as maturity approaches (and term shortens) and they revert to their par value, or the original price of the bond when it was issued.
Beyond these, an income fund can benefit from both higher yields provided by corporate bonds and preferred shares vs. government bonds, among others such as alternatives as we cited above, and tax-advantaged returns from capital appreciation.
Lastly, if you ever need access to your money, you are free to withdraw from the fund at any time. If you choose a GIC, you are locked into a fixed interest rate for a fixed period of time. If rates fall, you might feel good about your decision to lock-in, but you won’t necessarily do better than the fixed income fund. If rates rise, you won’t be able to take advantage of them. And again, if you need access to your money, you are stuck until the maturity date.
On balance, we believe that dynamic, diversified, and actively-managed income funds offer many advantages over GICs now and for the years to come, just as they have in the decades past.
If you have any questions about how we are managing our income portfolios and the opportunities for you as an investor, please reach out to your Client Portfolio Manager.