It has been quite a while since Canadians could buy a GIC with a rate of more than 4%.  In fact, we have to go back to 2007 to find rates comparable to what you see posted on retail bank branch windows today. This week, the best 1-year GIC rates were up in the 4.7% area, versus the paltry sub-1% rates we saw only two years ago. The rapid escalation this year follows what has happened to official policy rates and bond yields; and this development has prompted investors to ponder whether they should ditch some or all of their portfolios for these seemingly juicy offerings. The temptation seems intuitive, yet some careful consideration is needed before making snap decisions.

 

 

The chart above shows the Government of Canada 12-month treasury bill rate going back to 1997. I’m using this series since there is no one GIC rate out there.  In fact, there are a multitude of institutions that offer GICs. Some are insured under the Canadian Deposit Insurance Corporation (CDIC), while others are not. Some are rated high on the credit quality scale, whereas some are not even rated. Still, the 12-month bill rate is a good proxy for a 1-year GIC rate, though GICs will tend to be higher by 0.1-0.3%.  We may not be quite back to levels that we saw before the financial crisis, but the speed of this move is incredible.

 

Now, it’s not just the level of GIC rates that is causing some to move money into this space.  It is also the fact that GICs are viewed as safe. And, if they are CDIC insured, they are indeed safe (at least up to the $100,000 CDIC maximum). The desire for safety is going to be more pronounced in a year where both equity and bond markets have undergone higher volatility and declines in value. Hence, the combination of higher rates and safety explains the shift in investor decision-making at the margin.

 

To make a wholesale shift from say a balanced portfolio to GICs requires a trip to the mirror though. If risk tolerance has really dropped to zero (meaning no tolerance for any fluctuation in the portfolio), then a shift to a safe vehicle like GICs makes sense and is actually warranted. Investors, however, have to figure out whether their actual risk tolerance has dropped to zero or is just going through a transitory shift. There are investors out there that have asset allocations that are not aligned with their true risk tolerance and some of them, at times, need a year like this one to realize that. This happened in 2008-09, where investors who thought they could be 100% in the equity market, found out that a 50% hit was more than they could stomach. They re-calibrated and came out of the crisis with an asset allocation strategy that was more aligned with their tolerance.

 

But that isn’t what we are talking about here when someone thinks they should abandon their portfolio strategy for a GIC.  Many will say it’s just until the smoke clears. A fair point to be sure, given that no one knows when the smoke is going to clear, including the policy makers at the world’s central banks. I’m pretty sure that the Bank of Canada is going to hike rates by half a percent or more next Wednesday and that the Federal Reserve will do the same (if not more) at their November 2^nd meeting. Economic conditions will deteriorate and probably significantly, but when will the smoke clear? March of 2023? Or, perhaps by this time next year. Doing a wholesale exit of a portfolio for a 1-year GIC is implicitly a bet that risk assets are not going to start recovering before this time next year. Worse still, a decision to buy a longer-dated GIC is a bet that we are in this for two years or more.  Possible, but not very likely. Forget, for now, that there is basically no rate pickup on buying GICs longer than a year. In other words, you aren’t being paid a lot more to lock in money for more than a year.

What about the majority of investors who don’t believe they need the wholesale shift, but just want to throw GICs into the fixed income side of their portfolio? In my opinion, this would be roughly comparable to the decision to sell one’s stocks in early 2009, just before equity markets hit the trough of the financial crisis. Why am I saying that? Because the North American bond market has just gone through its worst correction in over 40 years and, with a recession waiting on our doorstep, this correction is getting close to ending.

 

 

Question.  Why do we have bonds and other liquid fixed income assets in a blended portfolio? First, they produce income. Second, they tend to be less volatile than stocks. Third, they also offer capital growth opportunities in times when economies are contracting. Now, that second reason didn’t exactly play out well this year. The total return on the Canadian bond market since the start of the year is close to minus 15%, compared to a 10% negative return for the TSX. Yet, this just underscores how rare this year’s bond market correction is. Unless you think central banks are going to add another 3% to their policy rates (meaning that we get to 6.25%), then the odds of repeating the negative returns of this year in quality fixed income (governments and investment grade corporates) are minimal.

 

What we do know is that central banks did make policy errors in keeping rates too low for too long and didn’t pull back their balance sheets soon enough. They look prepared to make another policy mistake on the other side – aka push the economy over the edge. Once the recession is acknowledged, rate hikes will stop and eventually rates will come down. That is where the bond portfolio checks all of the three boxes mentioned above. Income now is higher than it has been for years, stock market volatility will move ahead of bonds as the recession becomes reality and, when it looks like central banks are switching gears, bond yields will fall – meaning prices will rise. That means the total return on my bond portfolio will be a product of yield and capital appreciation.  The total return on my GIC portfolio will be just yield.

The underperformance of the GIC strategy doesn’t just end there. Let’s say the recession unfolds as we think and stocks enter another downward leg? This is a view that more and more analysts and traders are leaning towards and a key reason why Ally and I are taking more equity off the table in favour of income and cash (which now actually offers a reasonable rate of interest). Given that the stock market will tend to lead the actual economic cycle, the floor of the market will likely happen before the economy hits bottom. Bonds will also price in this economic trough and the resulting shift in central bank policy, leading to bond price appreciation. At some point, it will make sense to trim bond exposure and move the funds back into equities to capture the recovery. In a liquid bond portfolio, this is doable. With GICs where we are locked in until set maturity dates, the same is not be true.

 

This might sound like market timing, but it is not. It’s actually the essence of a disciplined asset allocation strategy. Today, we are tactically reducing equity exposure below the targets of individuals because it is prudent to do so over the near-term. Longer-term, however, investors should be at their target, which means if stocks have dropped substantially and bond values have improved, then it requires a rebalancing. Again, this can be done easily with a bond portfolio that can be trimmed at any time, versus the GIC.

 

 

The final comment I will make on the decision between bonds and GICs is that it is not just the ability to make adjustments to the portfolio that matters.  It is the yield that is available in bonds versus the term GIC. A properly diversified bond portfolio will have a mixture of government and corporate bonds, in addition to perhaps floating rate vehicles and liquid alternatives. Sometimes we may not want government bonds (like the start of this year), but generally they are held to provide a lower risk exposure compared to corporate bonds. Today, we have a very interesting environment where short-term investment grade corporate bonds are offering yields that are close to a full percent above what I can get on a GIC. The chart above shows the yield curve for Canadian bonds that are triple-B, the rating threshold for investment grade bonds.

 

As a result of the correction in fixed income this year, yields have spiked to the point where we can get yields in the 5.5% area for bonds that mature in a year. Again, these are investment grade companies, which means that their risk of not being around to pay us back is relatively low. If we hold the paper for a year, we outperform the GIC. However, if the economy turns and yield levels decline, then we might have the added benefit of getting a bump in the price of the bond. The most important consideration is that we can sell this bond whenever we want if we believe the time has come to re-enter the equity market.  I don’t want to make this sound like a “you can have your cake and eat it”, but for an individual that has the risk tolerance to hold stocks and to have a blended portfolio, it makes more sense to move funds into bonds on concern over the economy than into GICs.

 

Have a great weekend everyone

Andrew Pyle

 

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These are the personal opinions of Andrew Pyle and the Pyle Group and may not necessarily reflect those of CIBC World Markets Inc.