GICs (Guaranteed Investment Certificates) seem to have become fashionable once again. The interest rate hiking cycle implemented by central banks globally over the past year and a bit have forced short term lending rates to shoot up dramatically, making investment in GICs or other similar securities much more attractive than they have been for many, many years. But does that make GICs a good investment currently? Spoiler alert: the answer is NO!
For individuals who have a known liability due in 6-12 months and cash on hand now to pay for it, GICs might be a better solution than keeping the money under your mattress where it will earn nothing, or putting it all on the horse “Spend a Buck” to win, place or show in the third race. GICs will always be the smarter choice in this scenario, regardless if interest rates are 1% or 5%. Outside of this scenario, it is hard to justify why anyone would be well served by investing in a GIC.
Before we get into the details of why GICs are a poor investment option, let’s briefly review the basics of GICs:
- Banks or other financial institutions issue GICs, paying relatively low rates of interest. These institutions then lend this money to other borrowers for a much higher rate of interest, which has proven to be the best money-making racket in Canada’s history by a wide margin. If banks can earn higher rates of return elsewhere, then you probably could too!
- If the terms and conditions weren’t already extremely favourable for banks, they impose non-redeemable withdrawal restrictions to those who purchase GICs, making the investment extremely inflexible for the investor compared to most other investments. Of course, you could opt for a redeemable GIC for a significantly lower guaranteed return.
- The Canada Revenue Agency likes GICs too – because they will get the maximum number of tax dollars from your GIC investment held in a non-registered account. That may not matter for some, but for many, GICs are highly inefficient from a tax perspective.
For the Longer-Term Investor
This is the easiest case to address. Every theoretical and empirical piece of evidence would irrefutably conclude that GICs (or more broadly speaking “Cash equivalents”) would be the lowest performing asset class compared to other credible long-term asset classes such as stocks or bonds. Investing in cash over the long term would result in a sub-optimal outcome.
So why would a long-term investor buy a GIC? Because they are afraid of stocks or bonds going down in the near term and it makes sense to park assets in a GIC “temporarily” until the outlook improves for stocks and bonds to go up again. Sound familiar? That is a textbook example of market timing – another well-documented, terrible idea in investing.
For the Mid-Term Investor
The time horizon for a mid-term investor could be debated, but five years would seem like a reasonable length for most and also happens to be a pretty popular term for investing in GICs.
Here is the number one mistake that investors make when deciding on GICs vs. market-related securities: “GICs are currently guaranteeing X% for five years. My investments lost 5% last year. GICs are a no-brainer!” That is faulty logic in two respects: why are you comparing one-year returns against five-year returns and why are you comparing future returns against historical returns? As a Portfolio Manager and Chief Investment Officer, I regularly encounter that argument – no wonder why I went grey in my twenties!
To properly evaluate whether GICs have had any merit as a worthy investment, you must compare returns at the conclusion of the term, not the beginning. If you purchase a 5-year GIC with a stated 3.5% annual return, then your return will be 3.5% per year at the end of five years, but you won’t know the returns of any other non-guaranteed return until five years have elapsed. Fortunately, data exists for both GICs and market-based asset classes going back to the early 80’s allowing for fair and accurate comparisons.
By constructing portfolios consisting of various conservative asset classes, you can determine numerous investment combinations that have much more compelling characteristics than GIC returns. The simplest example would be to compare against the standard Canadian bond index (FTSE Canada Universe Bond Index). Backtesting monthly data for more than 40 years shows that the bond index beats GIC returns over five-year terms more than 90% of the time (and that includes an assumption for fees)! That is a promising starting point, but it is important to take more than a one-dimensional approach to evaluating investments.
From a behavioural perspective, investors in GICs tend to have some degree of risk aversion in their DNA. Seeing negative returns from their investments over any period may be unnerving. Since GICs are not market traded, their value never changes and thus, they never have negative periods. That is not the case for most market-traded securities. The five-year returns that we referenced above are comprised of 60 consecutive monthly returns, and for the nervous investor, any negative monthly period may be stressful. The downside of the bond index is that backtesting shows that it has had 58 monthly periods of negative returns – which is only 11% of the time, but perhaps too much for jittery investors to handle.
The solution to this potential problem is diversification. Instead of comparing against a single bond index, complement it with short-term bonds, higher yielding corporate bonds, preferred equity, common equity or even small doses of alternative investments like gold. There are endless combinations of these asset classes that if constructed properly, will allow you to generate that same 90+% success rate of materially better returns than GICs, and reduce the negative periods to a much more palatable number in the 20s or so (or less than 5% of the time). In addition to these two measurement points (5-year returns, number of negative monthly periods), we also measured and minimized 5-year volatility and negative one-year period statistics.
The bottom line from this analytical exercise is that over the past 40 years, you could have earned roughly an extra 2% per year (after fees) investing in what any investment professional would consider to be an extremely conservative portfolio, compared to 5-year GICs.
For the Short-Term Investor
One-year term GICs are currently quite popular as they offer a higher interest rate than longer-term GICs – that grabs people’s attention! The reason shorter-term rates are higher than longer-term rates is because there is a general consensus that interest rates will go down in the future. Interest rates have risen sharply due to high inflation, so it is fitting to assume that when inflation goes back down, interest rates will come down too.
There are two important consequences when interest rates go down: reinvesting matured GICs in the future will yield lower returns; and, when interest rates go down, bond prices go up. Since bonds constitute most of the compelling portfolio solutions analyzed in the Mid-Term Investor section, both of these consequences put GICs at a competitive disadvantage compared to bonds. If interest rates drop, it is very likely that GICs will underperform a bond portfolio, possibly by a considerable amount.
But what if the consensus is wrong and interest rates continue going up? Well, there is really only one scenario where that happens – if inflationary pressures re-emerge. Short-term interest rates tend to be highly correlated with inflation, and higher inflation is not good when you are already locked into a fixed rate of return.
Real rates of return, which adjust for inflation, measure the increase (or decrease) in purchasing power. If you have $1.00 to invest, and can purchase a 1-year GIC with a guaranteed rate of 4%, and if inflation during the next year ends up being 5%, then what used to cost $1.00 would now cost $1.05, but you only have $1.04 – you have lost purchasing power!
Since the Great Financial Crisis of 2008/2009, banks have become significantly more stingy on the spreads between what they pay and what they charge for loans. Going back to the beginning of 2009 and looking at monthly data, only 15% of the time will you actually earn a positive real rate of interest on 1-year GICs, with an average annual real return of -1.38%. That doesn’t seem like a very good “Guarantee” to me!
Don’t be fooled by what seems like a current attractive guaranteed investment return from institutions that are experts at engineering profit at your expense. GICs are a poor investment choice for the short, mid, and long term…and there aren’t any more terms to consider!
Data sources: Morningstar Direct, Bank of Canada