- One of the oldest questions in investing
is whether you should own individual bonds,
GICs, or bond funds to get your fixed income exposure.
Many people believe that bond funds are risky,
especially in a rising rate environment,
due to the potential for price fluctuations.
On the other hand, as the story goes,
individual bonds and GICs guarantee your principal.
This is true, but it is also misleading.
We always have to remember that what matters to you
as an investor is your total return.
That is what puts food on the table.
Bond returns come from three sources,
principal, interest payments,
and reinvested interest payments.
If we only focus on the preservation of principal
to determine what is safe,
we are missing the point
and doing our portfolios a disservice.
I'm Ben Felix, Associate Portfolio Manager at PWL Capital.
In this episode of Common Sense Investing,
I'm going to tell you how GICs and bond funds
fit into portfolios.
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In general, individual bonds are not ideal
for individual retail investors
because they require extensive research
and are relatively expensive and tricky to trade.
GICs, on the other hand, are very easy to purchase
and require no research
because they are backed by the CDIC,
a crown corporation responsible
for ensuring banking deposits when purchased properly.
For the remainder of this video,
we will compare GICs and bond funds.
GICs are excellent for meeting a known expense
at a known future date.
If you know that you want to buy a new car
in exactly two years,
and you have the cash available today,
you might buy a two-year GIC.
This will allow you to earn a reasonable amount of interest
without taking on any risk
that the cash won't be there when you need it.
For longer-term goals
that are less certain in timing and magnitude,
like saving for and then eventually funding your retirement,
the attraction of a principal guaranteed
diminishes substantially.
For example, when a retiree
with a GIC letter has a GIC mature,
they will likely buy another GIC to replace it.
This ends up being exactly the same thing
that is happening inside of a bond fund.
Other than the psychological pleasure
of having your GIC principal returned unscathed,
as opposed to watching your bond fund fluctuate,
you have not gained or lost anything
by owning a GIC instead of a bond fund.
Let's walk through what I'm talking about.
If you own XSB, the iShares short-term bond fund,
you have a weighted average maturity of 2.86 years,
a yield to maturity of 2.71 percent,
and an effective duration of 2.7 years.
You can think about duration
as the amount of time that it would take you
to recover your losses resulting
from a one percent rise in interest rates,
assuming a parallel shift in the yield curve.
Let's say you could alternatively buy
a three-year compound GIC
with the same yield of 2.7 percent.
If interest rates rise one percent,
your bond portfolio will take a hit of about 2.7 percent,
while your GIC does not change in price.
However, the bond fund
will immediately be reinvesting coupons and maturities
into new bonds issued at now higher yields.
It's kind of like dollar-cost averaging.
Your total return over 2.7 years
should be relatively unaffected all else equal.
Your GIC, on the other hand, would not change in price,
but you would also not be immediately investing
at the now higher yields until your GIC matures.
If interest rates rise,
the economic value of the future interest payments
from a given GIC are reduced.
While you do not see a paper loss in your account,
you're missing out on higher interest
until your GIC matures.
The end result in both cases is about the same
in an economic sense,
with the big difference being in the psychology
of daily pricing for a bond fund.
You actually have to watch the economic loss happen.
One important thing to remember about the bond fund, though,
is that while with all else equal
you would expect to earn the yield
to maturity at the time of purchase
if you hold the fund for a period equal to its duration,
you should not expect all else to be equal.
Bond total returns are not only affected by interest rates.
They are also affected by credit spreads
and the shape of the yield curve.
We have already talked about the ultimate sources
of long-term bond returns, principal, interest payments,
and reinvested interest payments.
Similar to stocks, there are known factors
that explain the difference in returns
between diversified bond portfolios.
These factors are term,
where longer term bonds have higher expected returns,
and credit, where lower credit bonds
have higher expected returns.
GICs are only CDIC insured up to five years.
So in a prudent portfolio
they will typically be a short maturity holding,
which means that they miss out on the term premium.
The term premium has been substantial over time,
with the caveat that for maturities over 10 years,
the risk return trade-off becomes relatively unattractive.
In any case, we can compare the returns
of a short-term Canadian bond index,
representative of what we might expect
from a five-year GIC,
to an aggregate bond index,
representative of what we might expect
from something like ZAG, the BMO Aggregate Bond Index ETF.
Going back to 1985, which is where my data starts,
we see an annualized return of 6.51 percent per year
for short term bonds,
and 7.97 percent per year for the aggregate bond universe.
Keeping in mind that short-term bonds
are included in the universe,
you can see how much the mid and longer-term bonds
bring up the average return.
To be clear, this period does capture the extent
of the greatest bull market in bond history
due to falling interest rates.
However, we would still expect the relationship
between longer maturities, which are riskier,
and shorter maturities, which are safer,
to hold true over time.
Risk and return should always be related
in diversified portfolios.
The fact that GICs are CDIC insured is interesting.
The highest yielding GICs are often issued
by relatively risky borrowers,
so the yields are high due to credit risk,
but the CDIC coverage makes them risk-free to the investor.
It's almost like a government subsidized
arbitrage opportunity.
The risk-free credit exposure
is an attractive characteristic of GICs
that is not shared by bond funds.
So far, the most attractive characteristic of GICs
is that they don't look scary when rates rise,
but we've established that as not a real economic benefit.
We've also established that GICs miss out
on the term premium,
which has been substantial over time.
This point is not a knock against GICs.
GICs could reasonably make up
part of the shorter-term fixed income allocation
in a diversified portfolio.
There are a few more important characteristics to consider.
As I mentioned earlier,
GICs cannot be sold on the open market.
This means that they are illiquid.
Their illiquidity may contribute
to their relatively attractive returns
compared to short-term bonds,
but it also causes an issue in managing in your portfolio.
If stocks fall in price,
you may need to sell some of your bonds to buy more stocks.
This act of rebalancing becomes problematic
if all of your fixed income is in illiquid GICs.
Based on this, you would want to hold
at least some bond funds alongside your GICs for liquidity.
The majority of investors in Canada
have a massive home bias in their fixed income allocations
Canadians on average get around 90 percent
of their bond exposure from Canadian bonds,
while the Canadian bond market makes up
only about two percent of the global bond market.
In the past, there has been a good reason for this.
You do not want to own bonds in other currencies.
The volatility of currencies far outweighs
the volatility of bonds.
Owning a bond that is priced and pays interest
in a different currency might end up behaving
more like a stock in your investment account,
but without the higher expected return.
When global bond exposure
is hedged back to Canadian dollars,
there is without question
a diversification benefit to be gained,
mostly due to interest rate diversification.
Local risk factors like inflation, economic shocks,
and central bank policy generally result
in less than perfect correlations
in interest rates globally.
In a 2013 paper from Vanguard,
it was demonstrated that a hedged global bond portfolio
would have produced a better outcome
than an investors local bond market
in the majority of rising rate periods across Australia,
Canada, Europe, Japan, Switzerland,
the UK, and the US going back to 1995.
Thinking about this practically,
it just means that interest rates
in every country around the world
are unlikely to rise the same magnitude at the same time,
which should offer a diversification benefit.
That diversification benefit does show up in the data.
We can observe it for a Canadian investor
by comparing the FTSE TMX Canada Universe Bond Index
to the Bloomberg Barclays Global Aggregate Bond Index
hedged to Canadian dollars.
I have data going back to February 1999.
From that date through December 2017,
Canadian bonds returned to 5.26 percent,
with a standard deviation of 3.66 percent,
while global bonds hedged to Canadian dollars
returned 4.85 percent,
with a much lower standard deviation of 2.72 percent.
Keeping in mind that the goal of fixed income
is to reduce portfolio volatility, the similar return
and significantly lower standard deviation
of global bonds hedged to Canadian dollars is attractive.
Until 2014 ,there were not any low-cost
global bond index funds hedged to Canadian dollars
available to DIY investors.
As of now, Vanguard does have VBG and VBU,
which together offer access to the global bond market
hedged to Canadian dollars.
These are the funds used for bond exposure
in Vanguard's asset allocation ETFs.
It may feel like we've gone down a bit of a rabbit hole
on global bond diversification here,
but it ties back to our main topic.
GICs do not offer exposure to the global bond market.
Every dollar added to a GIC
is a dollar that cannot be allocated to global bonds.
With that said, in a 2018 paper from Vanguard,
it was demonstrated that adding currency
hedged to global bonds to a portfolio
has a meaningful but decreasing effect
on volatility reduction,
as the allocation to global bonds increases.
In other words, as long as you allocate some
to currency hedged global bonds,
you do not need to have your whole fixed income allocation
in currency hedged global bonds
to get most of the volatility reduction benefit.
I need to touch on tax efficiency.
When interest rates fall, bond prices rise
such that their yield to maturity matches the market.
Bonds always mature at par.
This means that if you buy a bond issued at $1,000,
for $1,100 after rates fall,
you will only get $1,000 back when the bond matures.
Now, over the life of the bond,
you will also get interest payments at above market rates,
such that the combination of above market interest
and the capital loss at maturity will give you
the yield to maturity that you would expect to earn
based on market rates.
Before taxes are considered,
you end up in the exact same position
as someone who bought their bond at par
and earned market rate interest until maturity.
The problem for a taxable investor holding a premium bond
is that you were receiving interest payments
at above market levels,
and then incurring a capital loss
to arrive at your yield to maturity.
The heavier weight and interest
results in more tax owing, with nothing gained.
A GIC will never suffer from this issue
because you cannot buy a GIC
that has gone up in price on the secondary market.
GICs are always at par.
This can make GICs relatively attractive
on an after-tax basis in taxable accounts,
under certain conditions.
However, there are also fixed income funds,
like ZDB from BMO, which avoid holding
tax-inefficient premium bonds.
The premium bond issue is not permanent.
If interest rates stay the same forever,
bond yield to maturity and average coupon
will end up being the same.
It is only when we have long periods of falling rates
that premium become problematic.
Let's quickly recap.
Total return is all that matters.
Whether your bond fund drops in value
or you earn below market interest
while you wait for a GIC to mature,
the economic effect is the same,
but GICs might help you sleep better.
GICs miss out on most of the term premium,
but they could fit into the short-term fixed income portion
of a diversified portfolio.
GICs are illiquid, so if they are used,
they should be used alongside bond funds for liquidity.
GICs miss out on global diversification,
but you don't really need your whole fixed income allocation
to consist of globally diversified currency
hedged fixed income anyway, as long as you have some.
Finally, GICs can offer attractive after-tax returns
in a falling rate environment
because they sidestep the premium bond issue altogether,
but this benefit is time period specific.
That was a pretty deep dive into fixed income.
I do hope it was still interesting.
In the end, I do not think
that there is an objectively right answer
on the question of bond funds versus GICs.
Both have advantages in certain situations,
but I think that it mostly comes down to preference.
If having a GIC ladder as part of your retirement portfolio
helps you sleep at night, I see no problem with that.
My preference is bond funds
for their diversification, better exposure to the factors
that explain fixed income returns, and liquidity.
If I had bonds in my portfolio, that is what I would own.
Do you prefer bond funds, GICs, or a combination of the two?
Tell me about it in the comments.
Thanks for watching.
My name is Ben Felix of PWL Capital
and this is Common Sense Investing.
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