What a disappointing few years it's been for buyers of guaranteed investment certificates. Year after year, investors have been told interest rates were about to rise. But they have fallen instead. In the past couple of months, the benchmark Canada 10-year bond yield has plunged to a dismal 1.24 per cent from more than 2.25 per cent.
Bonds – deemed far more risky than staid old GICs – have been impressive in their price rise since the 2008 financial panic. Bond yields and prices tend to move in the opposite direction.
Inflation, meanwhile, has been playing dead.
But wait. Before you throw in the towel on your risk-free investments, step back and look at what's going on in the world. Deflation in Europe, a slump in Canada, problems in the Japanese, Chinese and Russian economies, trembling emerging markets: This is no time to take on more risk than you can tolerate.
Besides, you may be rewarded for your patience before the year is out, or soon thereafter. Consider the giant U.S. economy – self-sufficient, adaptable, vibrant, fed by cheap oil. It wasn't mere rhetoric when U.S. President Barack Obama said in his State of the Union speech: "Our economy is growing and creating jobs at the fastest pace since 1999. … Our unemployment rate is now lower than before the financial crisis."
With the U.S. central bank, the Federal Reserve, expected to begin raising short-term interest rates later this year, it's not difficult to imagine that the endless slide in long-term interest rates could be reversed, first in the United States and later in Canada – regardless of how weak the Canadian economy may be at the time.
Indeed, some market watchers south of the border say simply that bond yields should be double what they are. The rule of thumb is that the level of long-term interest rates should almost equal the sum of real GDP (gross domestic product) growth and inflation, according to the Jeroen Blokland Financial Markets Blog. The model suggests 10-year U.S. yields of 4 per cent, not 1.7 per cent. The comment was published before the oil price plunge, which will lower inflation somewhat.
Mind you, a growing number of market watchers think the bond market is responding to soft inflation data and possibly slower U.S. growth ahead, but the analyst doesn't believe that.
The reason long rates are inexplicably low, the writer says in the blog, is that investors have grown accustomed to a world of shaky economic fundamentals and low inflation in which central banks come to the rescue. Things are unlikely to change before late this year at the earliest, when bond markets wake up to the reality of solid, sustainable U.S. GDP growth and stable and even rising prices.
If and when U.S. interest rates rise, the Bank of Canada will eventually be forced to respond by raising its short-term rate, or it will risk a run on the dollar and serious instability in currency markets.
Bear this in mind when you go to roll over your GICs this RRSP season. Be cautious about going out more than three years.
So how much of your savings and investments is it sensible to have in GICs?
For most people, GICs will form part of the fixed income side of their portfolio, says Kurt Rosentreter, a financial adviser and chartered accountant at Manulife Financial in Toronto. "The role of GICs is less about return and more about stability, flexibility and cash flow," he said in an interview.
GICs are also ideal for people who are saving for something in particular in the not-too-distant future – a home, or child's imminent entry into university – and can't risk ending up with less than they started with. "Over five years, inflation is not going to be much of a factor," he says.
Some people hold their entire life savings in GICs. They may be so wealthy that they can live off the GIC yield rather than relying on capital gains from stocks. Or they are just accustomed to them and don't want to change.
"There's an industry out there happy to lead you into the stock market whether you want it or not," Mr. Rosentreter says. "People have to push back and say, 'It's not for me.'" But he recommends staying away from index-linked GICs – high-cost investment certificates linked to stock market indexes.
The downside of GICs and other fixed income investments is that your capital could be eroded over the long term by inflation. As well, if interest rates were to jump suddenly, as they sometimes do, you would have to wait until the GIC matures to roll it over and get the higher rate.
Canada Deposit Insurance Corp. covers you for GICs of up to $100,000 (maximum five-year term) at each financial institution. U.S. dollar GICs are not insured.
How to use GICs
Nervous investors often hold money in one-year fixed-income investments such as GICs, hoping interest rates will rise. A better strategy might be to build a GIC ladder, says Clay Gillespie, a financial planner at Rogers Group Financial in Vancouver. To do this, you would invest equal amounts in GICs having five different maturities, ranging from one to five years. (If you believe interest rates really will rise this time, you may want to pare this to a maximum of three years.) This would give you an overall return that is higher than that offered on other short-term guaranteed investments.
"This type of strategy takes the guesswork out of investing in fixed-income vehicles and allows you to have predictable returns over the years," Mr. Gillespie says.
A GIC ladder also offers some liquidity. "Since one-fifth of your portfolio matures each year, you can spend that entire maturity if the funds were required," he notes.
GICs may not generate much income, but they give you a secure portfolio you can draw from in retirement.
Mr. Gillespie offers the following example: If you invested $100,000 in a portfolio of GICs at age 65, you should be able to generate about $324 a month, indexed at 3 per cent annually, to age 90, when the money runs out, he notes. That assumes a 2.5-per-cent rate of return.