In praise of a much maligned investment

A lot of the investors who sought safety in bond funds in the past year made a choice that could eat into their returns and spoil their peace of mind.

If these people had bought guaranteed investment certificates (GIC) instead, they would quite possibly be making more money right now with less downside pain when interest rates start to move higher.

The GIC - is there a more underappreciated an investment product? By the time you finish this edition of the Portfolio Strategy, your answer will be an emphatic no.

Until the mid-1990s, GICs were the investment product of the masses. Then interest rates went into a long-term decline and investors started looking elsewhere for decent returns. That's pretty much the story of the rise of the mutual fund industry.

A year ago, investor interest in safe investments surged as the stock markets tanked. Bond mutual funds were the big hit with conservative types, along with bond exchange-traded funds and high-interest savings accounts. GICs? At Victoria-based GICDirect, sales slumped last March and only now show signs of recovery.

"I think GICs get a bum rap with investors," said GICDirect president Bill Ritchie. "I've said that for years."

Mr. Ritchie's firm has been in business for about 10 years and during that time he said it has consistently been able to offer five-year GIC rates that beat comparable Government of Canada bonds. He said he couldn't verify whether GICs beat provincial bond yields, but I can.

CIBC Investor's Edge is one of a few online brokerage firms that offer GICs from a wide variety of third-party banks, trust companies and credit unions. This week, it had five-year GICs available from HSBC Bank and Laurentian Bank at 3.35 per cent. At the same time, Investor's Edge was selling a Government of Canada bond maturing in mid 2015, with a yield of 2.6 per cent and comparable provincial bonds with a yield of 2.8 per cent.

GICs also beat the yield provided by bond ETFs. The Claymore 1-5 Year Laddered Government Bond ETF (CLF-TSX) is designed to be a convenient substitute for finding government bonds with terms of one through five years and investing equal amounts in each. The best yield estimate for this product right now is about 1.9 per cent after fees. If you used one- through five-year GICs available from Investor's Edge, you could build yourself a laddered portfolio yielding an aggregate 2.4 per cent.

No, that's not a great return. You could do better with dividend-paying blue chip stocks, preferred shares, income trusts and so forth. But if you've been buying bonds and bond funds lately, you're probably too conservative for those.

Let's consider the safety factor. There's a supreme level of safety with bonds issued by governments, which can ultimately raise taxes to pay what they owe. With riskier corporate bonds, you're dependent on the ability of a company to pay what it owes.

GICs issued by virtually all financial institutions that deal with retail customers are members of Canada Deposit Insurance Corp. (CDIC), a federal agency, or provincial credit union deposit insurance plans. CDIC limits coverage to $100,000 in principal and interest per institution, but you can get around this by spreading your investments among various financial companies.

Bonds and bond funds beat GICs in two areas - variety and liquidity, which means the ease with which you can buy and sell them at a fair price.

With GICs, the key variables in choosing what to buy are basically rate, term and the reputation of the firm issuing them. There are some particular features to consider - like the option of being able to cash out before maturity without any hassles - but they're minor.

With bonds, you have a much broader choice that ranges from super-safe Canada bonds through provincials, investment-grade corporate bonds and high-yield bonds, which are issued by companies with less than sterling financials and are about as risky as stocks. Bottom line, bonds offer lots of room to take on more risk than GICs and get higher yields.

You can also sell a bond before it matures, while bond funds can be sold any time. You may lose money on the sale or realize a profit, but the fact remains that you can ditch them if you need to.

Here's how Mr. Ritchie describes the liquidity of GICs that are not specifically designed to be cashable: "With most institutions, you have to consider the money locked in." Still, he said that exceptions may be made hardship cases where someone has, for example, lost a job. The amount of interest paid out in these situations varies.

There's some compensation for the lack of liquidity in a GIC. If there's no market for selling them before maturity, then there's no need to track daily prices as they rise and fall in response to interest rate changes. Net result: the value of a GIC in your account will remain steady as rates rise or grow in value to reflect the interest payments you're accruing. If rates rise, bonds and bond funds fall in price.

Bonds eventually mature just like GICs, so investors need only persevere through periods where bond prices are falling. With bond funds, you can only recoup losses when the interest rate environment turns favourable again.

Another GIC advantage over bond funds - you know exactly how much income you're getting. The technicalities of bond funds, including bond ETFs, make it hard to be sure of how much you'll get in interest payments.

GICs offer highly competitive rates to conservative investors, and yet it's bond funds that became a refuge in the bear market. Mr. Ritchie said one reason could be that investment advisers are better compensated for selling bond funds and individual bonds.

He said GICDirect makes a commission of 0.25 per cent of the amount a client invests per year of term (0.75 per cent for a three-year GIC, for example). As a specialist in GICs, the firm makes much more for selling these products than the typical investment adviser. As for bond funds, an adviser and his firm would share in continuing commissions equal to as much as 0.5 per cent of the amount invested. Also, GICs are not sold with upfront fees, although this is possible for bond funds

People may also be turned off GICs by the low rates advertised by banks, Mr. Ritchie said. "People are looking at rates that their retail banks are offering and saying, why would I lock in for five years at 2 per cent?"

GICs can also appear less convenient than bonds and bond funds in that they're not as easy to integrate into your investment account. In fact, many discount and full-service investment dealers offer access to a wide range of third-party GICs that you can drop into the fixed-income part of your portfolio.

About to buy a bond fund yourself, or through an adviser? Give GICs a thought. They're underappreciated, but they deliver for conservative investors.

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The ABC's of GICs

Key Advantages

• Higher rates than you can get from comparatively safe government bonds

• Won't fall in price as interest rates rise, like bonds and bond funds

• Available from investment dealers, which means you can use them in your portfolio as a bond or bond fund substitute

• Deposits are covered by deposit insurance

• Cost nothing to buy, unlike bond ETFs and some bond mutual funds

Key Disadvantages

• Can't easily be sold before maturity unless you have a cashable GIC

• Best rates sometimes available only small players you have to deal with directly

• Fewer opportunities than with bonds to take on more risk in order to make higher returns

Rate Comparison