GUEST EXPERT. Over the past year, central banks in major economies, including Canada, have gradually and rapidly raised interest rates from what appeared to be abnormally low levels. Following these increases, some non-convertible guaranteed investment certificates (GICs) now offer annual returns of between 5% and 6% with maturities ranging from one year to five years. The yields offered by this asset class have reached a peak not seen since at least the financial crisis of 2008-2009.
In such a context, some of our clients are rightly wondering whether it would be a good idea to sell all their shares and hold these non-redeemable GICs instead. The prospect of experiencing no volatility and getting a guaranteed return, known in advance and issued by a major financial institution, can certainly seem attractive. It’s even more when we consider that the Canada Deposit Insurance Corporation (CDIC) offers an additional guarantee of up to $100,000 for individuals.
First of all, it is worth remembering that investing in stock market investments should normally be done with a long-term perspective. Since the stock market is unpredictable and tends to fluctuate in the short term, it remains essential to maintain this long term horizon in order to benefit from the appreciation it provides.
Despite the volatility it exposes investors to, the stock market (S&P 500 Index) has historically provided an annual return of around 10%. Therefore, in our view, it is unwise to replace the equity investable portion with GICs with almost half the yield. For example, if you invested $300,000 in a GIC with a 5% return, you would end up with nearly $383,000 after five years. The same amount invested evenly in the S&P/TSX Toronto Index and S&P 500 exchange-traded funds should be worth $483,000 or $100,000 more* after five years. That’s a high price to pay to avoid the swings inherent in the stock market.
If replacing stocks with GICs is not a good idea, does it make sense to replace the portion of the portfolio normally devoted to fixed income securities with these same GICs? To answer this second question, it is important to consider that investing in GICs comes with a huge opportunity cost. Since non-exchangeable GICs cannot be traded, the capital invested in them is literally imprisoned until maturity. With these amounts tied up, it will be impossible for the saver to seize the next more interesting investment opportunity or even compensate for one of the many contingencies that occur in everyday life. A leaking roof, a car that dies or a divorce can suddenly make you regret making such an investment.
“Either! In this case, I’ll invest in a redeemable GIC,” some savers retort. The problem is that to achieve the stated annual return of 5% to 6%, the chosen GIC must be non-redeemable by maturity. Convertible GICs generally offer a significantly lower rate of return, so the original idea of investing in them at an attractive rate is simply moot.
An alternative to consider
A good alternative to GICs for the fixed income portion of your portfolio would be to consider high quality bonds. For example, the Canadian government offers an annual rate of return of almost 5% for maturities between 1 year and 5 years. Some high interest accounts, also protected by SADC, also offer a return of more than 4% per annum. In both cases, these investments are liquid, fluctuate much less than stocks—or not at all for high-interest accounts—can be redeemed or resold at any time, and offer returns close to those provided by GICs.
An investor who insists on holding non-redeemable GICs in his fixed income portfolio against all odds should ensure that they allocate only a fraction of his total fixed income weighting. It should also provide additional sources of liquidity available between now and CPG maturity. In this way, the saver would deprive himself of the opportunity to seize a better investment opportunity, in the worst case, he would expose himself to financial problems in the event of an unforeseen event.
* This example is based on an average annual return of 10% from the stock market and is for illustration purposes only. The S&P 500 Index has provided an average annual return of approximately 11% since 1926. Past returns are not indicative of future returns.
Eddie Chandonnet is a portfolio manager and partner at Medici.