Bond ETFs and Mutual Funds versus Guaranteed Investment Certificates (GICs)
Ashish Dewan, CFA®, CFP | Portfolio Consultant, Vanguard
Canadians are facing a unique situation when it comes to portfolio construction and investing decisions in the current market environment. A difficult economic situation, paired with high inflation and a steep and rapid tightening cycle by the Bank of Canada has led to a challenging investing climate that hasn’t been seen in many years.
Within this backdrop, stock and bond correlations have risen significantly, with both asset classes declining – a rare occurrence historically. Since 1976, investors have encountered simultaneous losses in stock and bonds over a one-year span in only 0.6% of instances. This rising stock/bond correlation, along with heightened risk aversion and improved returns, has resulted in many Canadian investor substituting Guaranteed Investment Certificates (GICs) for traditional bonds.
This decision can be based on many factors but first and foremost, it is dependent on the unique needs of each client, namely their investment objective, time horizon and risk tolerance.
Investment Objective, Time Horizon, and Risk Tolerance
GICs can be appropriate for shorter-term savings and investment needs, such as an upcoming car purchase or down payment on a home. Advisors should also consider the client’s risk tolerance as well in how they navigate the regular ups and downs of a volatile market. For some clients, principal protection is a priority, and in these instances a GIC would make a perfectly suitable investment, assuming the client does not have immediate liquidity needs.
For most other investors, who have the ability and willingness to assume risk and have a longer time horizon for investing they should almost always prefer bond ETFs and funds over GICs due to their substantial diversification benefits and superior total returns over the longer term.
For most investors, bonds ETFs and funds offer several advantages over GICs. We find four main advantages to choosing bond ETFs and funds over GICs including better portfolio return expectations, enhanced portfolio diversification, a more positive long-term outlook and greater liquidity. We highlight each of these four points in greater detail below.
GIC’s are guaranteed for payment of principal plus interest based on the credit worthiness of the issuer and their ability to pay. There's additional protection if the issuer is a member of CDIC which insures deposits, including GIC's, up to $100,000. The security of that guarantee generally involves foregoing return potential. This is evident in historical real or inflation-adjusted returns as GICs have underperformed bonds over the long term. Similar to owning stocks in lieu of bonds, owning GICs in lieu of bonds will almost certainly result in underperformance over the long-term.
1Average 1 Year GIC returns, courtesy Bank of Canada. FTSE Canada bond returns, courtesy Morningstar. Inflation index provided by the St. Louis Federal Reserve, using the Canadian Consumer Price Index.
As we can see in the chart above, if you had invested a million dollars in a broad based bond index in November, 1980, you would have approximately $21 Million dollars in September, 2022. However, investing a million dollars in 1-year GICs would have resulted in only $5 Million. Additionally, you’d need about $3.5 million dollars today to match the purchasing power of a million dollars in November 1980 due to the impact of inflation. Over the long run, an asset class with a low-risk premium, or in the case of a GIC, a negligible risk premium, will most likely result in lower relative returns over the long-term.
Even during periods or rising rates, total returns from bonds can increase if your investment horizon is longer than your bond’s portfolio duration. That’s because higher yields on reinvested cash flow outweigh the market price decline as evident from the table below.
By calibrating their bond portfolio to their time horizon, investors could have less to fear from rising rates
The illustration above is on a hypothetical investment in a bond maturing in 15 years that pays a coupon of 0.9% annually with interest rates at 2% and assumes a duration of 14 years. Over a period of 15-, 20-, or 25-years, interest rate rises of 100 and 200 basis points result in an improvement in total returns. This table conveys how rising rates can result in improved total returns, illustrated by the annualized returns shaded in green. Additionally, diversification benefits also improve during periods of high interest rates as higher yield provides a cushion that can help absorb some of the pain during equity market declines. From a price appreciation standpoint, GICs have no upside potential. If rates fall, there would be no impact on the rate your GIC pays. However, a diversified bond ETF or fund, would almost certainly have price appreciation. However, if short-term rates rise after you purchase GICs, you cannot take advantage of the higher rate without a penalty.
Most investors hold a multi-asset portfolio comprised of both stocks and bonds, and in some instances alternative investments. High quality bonds have historically acted as a shock absorber during equity market declines and Vanguard expects that trend to continue. They remain a source of income, liquidity, diversification from riskier assets and potential capital return.
GICs don’t provide significant diversification benefits as their price does not change. Below, we can see some of the correlation benefits diversified bonds have provided historically. As with any investment performance, looking solely at short periods will tell you only so much. Since 2000, short-term stock-bond correlations have spiked into positive territory on numerous occasions. Correlations over the longer term, however, remained mostly negative, and we expect this pattern to persist. The yellow line in the chart below illustrates longer term correlations which have always been 0 or negative since 1999.
Sources: Vanguard, using data from Refinitiv.
If we look at the Canadian market, the story is similar with short-term stock and bond correlations being erratic whereas longer term correlations, on average since 1981, are close to 0. Correlations were calculated using the S&P/TSX Composite and the Bloomberg Aggregate Canadian Float Adjusted Bond Indices.
A brighter outlook for fixed income
Investing in bonds in 2022 hasn’t produced the return or diversification benefits one expected. However, the outlook for fixed income is brighter over the longer term. Ironically, the worse returns get, the better bonds should look in the future. Investors who exhibit discipline during these periods are often rewarded. Ever higher coupons have changed expected return calculations and brought back bonds’ long-established use case.
As the Bank of Canada continues hiking rates, we should see inflation continue its gradual move downwards. As the economy slows, we expect Canada to experience a mild recession with average annual growth of around 0.7% in 2023. The beginning of a recession is usually accompanied by a flight to quality with bond prices going up and yields going down, particularly on the longer end of the maturity spectrum. The unusually positive return correlation we’ve seen this year between stocks and bonds may fall, and the lockstep downward spiral of the two asset classes may end. The main reason for the positive stock/bond correlation has been a rise in unexpected inflation along with the anticipation of quantitative easing removal. Additionally, as rates rise and inflation falls, bonds would be well positioned to provide strong real returns.
GICs, on the other hand, despite never declining, have limited upside potential.
Rising rates have improved Vanguard’s projection of forward-looking returns for Canadian and International bonds. Vanguard’s projections are based on the Vanguard Capital Markets model (VCMM). VCMM uses sophisticated statistical techniques to estimate future asset class returns.
VCMM forward-looking returns for bonds has improved
IMPORTANT: The projections and other information generated by the VCMM regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. Distribution of return outcomes from VCMM are derived from 10,000 simulations for each modeled asset class. Simulations as of June 30, 2022. Results from the model may vary with each use and over time. For more information, please see the “Important information” section.
Note: Percentages in the chart reflect the probability of the annualized return of the portfolio (columns) exceeding the average annualized inflation rate (rows) over a 10-year time horizon.
Source: Vanguard calculations. Data as of September 30, 2022.
Liquidity and other considerations
GICs are less liquid than broadly diversified bond ETFs and funds. There is no open market to trade GICs and you can’t trade GICs in your investment account prior to maturity. Some GICs allow you to redeem early at a significant penalty or have a “cashable” rider, which generally offer lower relative yields. As of January 3, 2023, a One-Year cashable GIC1 has a yield that is 1.65% lower than a non-redeemable GIC. An alternative to GICs is high-interest savings account (HISA) which do offer good liquidity. However, HISAs ETFs usually offer lower yields than both diversified bond funds/ETFs and GICs, although over a few time periods, HISAs, and even GICs, have offered higher yield than a diversified bond fund or ETF. HISAs also don’t offer the Canada Deposit Insurance Corporation (CDIC) protection therefore they are not “guaranteed.”
A limitation of the CDIC guarantee is that the maximum $100,000 coverage per institution encompasses GICs, deposits, chequing and savings accounts. The coverage is cumulative for all these accounts including GICs.
In terms of taxes, GICs, unless bought in the secondary market, are always taxed at 100% of a client’s marginal tax rate whereas bond ETFs/funds have the potential for capital appreciation which can be taxed as capital gains.
Bond ETFs and funds hold several advantages over GICs in terms of better return expectations, greater portfolio diversification, a brighter outlook and liquidity. Low-cost and diversified bond ETFs and funds provide building blocks that can help advisors add value to their clients’ portfolios and maintain long-term perspective and discipline. GICs, on the other hand, can be suitable investments for clients who require principal protection and have a short-time horizon.
1Royal Bank of Canada rate as at November 15, 2022
IMPORTANT: The projections or other information generated by the Vanguard Capital Markets Model regarding the likelihood of various investment outcomes are hypothetical in nature, do not reflect actual investment results, and are not guarantees of future results. VCMM results will vary with each use and over time.
Publication date: January 2023
The information contained in this material may be subject to change without notice and may not represent the views and/or opinions of Vanguard Investments Canada Inc.
Certain statements contained in this material may be considered "forward-looking information" which may be material, involve risks, uncertainties or other assumptions and there is no guarantee that actual results will not differ significantly from those expressed in or implied by these statements. Factors include, but are not limited to, general global financial market conditions, interest and foreign exchange rates, economic and political factors, competition, legal or regulatory changes and catastrophic events. Any predictions, projections, estimates or forecasts should be construed as general investment or market information and no representation is being made that any investor will, or is likely to, achieve returns similar to those mentioned herein.
While the information contained in this material has been compiled from proprietary and non-proprietary sources believed to be reliable, no representation or warranty, express or implied, is made by The Vanguard Group, Inc., its subsidiaries or affiliates, or any other person (collectively, "The Vanguard Group") as to its accuracy, completeness, timeliness or reliability. The Vanguard Group takes no responsibility for any errors and omissions contained herein and accepts no liability whatsoever for any loss arising from any use of, or reliance on, this material.
This material is not a recommendation, offer or solicitation to buy or sell any security, including any security of any investment fund or any other financial instrument. The information contained in this material is not investment advice and is not tailored to the needs or circumstances of any investor, nor does the information constitute business, financial, tax, legal, regulatory, accounting or any other advice.
The information contained in this material may not be specific to the context of the Canadian capital markets and may contain data and analysis specific to non-Canadian markets and products.
The information contained in this material is for informational purposes only and should not be used as the basis of any investment recommendation. Investors should consult a financial, tax and/or other professional advisor for information applicable to their specific situation.
In this material, references to "Vanguard" are provided for convenience only and may refer to, where applicable, only The Vanguard Group, Inc., and/or may include its subsidiaries or affiliates, including Vanguard Investments Canada Inc.
All investment funds are subject to risk, including the possible loss of principal. Diversification does not ensure a profit or protect against a loss in a declining market.
Investments in bonds are subject to call risk, credit risk, income risk and interest rate risk. Please see the prospectus for a description of the unique risks applicable to bond investing.
Currency hedging transactions incur extra expenses, may not perfectly offset foreign currency exposures, and may eliminate any chance to benefit from favourable fluctuations in those currencies.