Guaranteed investment certificates don't get a lot of respect. With yields topping out at a little more than 3 per cent for a five-year term, it's perhaps not surprising that some investors are giving GICs a pass.
But even in a low interest rate environment, GICs can play a useful role in a well-diversified portfolio. In my kids' registered education savings plan, for example, I like to play it safe so I allocate a portion of the funds to GICs. They provide stable returns, reduce the overall volatility of the portfolio and make it easier to live with the ups and downs of the stock market.
Here are several reasons that GICs may deserve a place in your portfolio as well.
They're easy to understand
Bonds can confusing. Not everyone has the time or inclination to understand bond prices, coupon payments, current yields and yields-to-maturity (my Five-Minute Bond Boot Camp explains the basics). GICs, on the other hand, are dead simple: You invest your money, earn a certain amount of interest annually (which is added to the principal if you choose a compound GIC) and at the end of the specified term you get your money back.
They're not volatile like bonds
When interest rates rise, bond prices fall. When rates fall, bond prices rise. Not so with GICs. Because most GICs must be held to maturity and don't trade in the secondary market, their prices don't fluctuate like stocks and bonds. Admittedly, the benefit is partly psychological: GICs are really just bonds with a fixed holding period. But the absence of price swings provides comfort in turbulent times.
The yields are higher than government bonds
Five-year Government of Canada bonds yield about 1.8 per cent – considerably less than the top five-year GIC rate of 3.15 per cent, according to RateSupermarket.ca. But they're both safe: Bonds are backed by the federal government and GICs of five years or less are covered for up to $100,000 if the financial institution is a member of the Canada Deposit Insurance Corp. (Credit unions typically belong to provincial deposit insurance plans, so you're covered there, too.)
So why are GIC yields higher? It comes down to the lack of liquidity. In exchange for locking in your money, you get a higher yield than you would with a bond that can be sold at any time.
To be sure, not having access to the funds is a downside for some people, which is why you should never invest in a GIC (apart from a cashable GIC) if you may need the funds before maturity. On the other hand, for those who have adequate cash resources elsewhere, the inability to access GIC funds can serve as a forced savings tool.
It's easy to shop around
If you're buying an individual bond, you're restricted to the inventory available from whatever broker you are using. Unless you have multiple brokerage accounts, it's hard to know if you're getting hosed or not.
With GICs, websites such as RateSupermarket.ca and Globeinvestor.com make it easy to comparison shop. (Google "Compare GIC rates.") Some brokers also let you purchase GICs from different financial institutions.
Laddering is a snap
To control interest rate risk, one popular option is to create a ladder of GICs with maturities ranging from one to five years. When the one-year GIC matures, reinvest the proceeds in a new five-year GIC. Do the same thing with the two-year GIC when it matures. And so on. By following this approach, you'll always be reinvesting your money for a five-year term, which has the highest interest rate. Laddering has other benefits: It gives you access to a portion of the cash once a year if you need it, and it prevents a situation where all of your money matures at a time of low interest rates. Think interest rates will rise? You could always shorten your ladder by a year or two (for example, four GICs ranging from one to four years in length). That way, your money won't be tied up for quite as long.
I'm not against bonds or bond exchange-traded funds. Both have their place. But GICs can be a great savings tool if you use them wisely.