Bond Fund Vs GICs - YouTube

- One of the oldest questions in investing

is whether you should own individual bonds,

GICs, or bond funds to get your fixed income exposure.

Many people believe that bond funds are risky,

especially in a rising rate environment,

due to the potential for price fluctuations.

On the other hand, as the story goes,

individual bonds and GICs guarantee your principal.

This is true, but it is also misleading.

We always have to remember that what matters to you

as an investor is your total return.

That is what puts food on the table.

Bond returns come from three sources,

principal, interest payments,

and reinvested interest payments.

If we only focus on the preservation of principal

to determine what is safe,

we are missing the point

and doing our portfolios a disservice.

I'm Ben Felix, Associate Portfolio Manager at PWL Capital.

In this episode of Common Sense Investing,

I'm going to tell you how GICs and bond funds

fit into portfolios.

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In general, individual bonds are not ideal

for individual retail investors

because they require extensive research

and are relatively expensive and tricky to trade.

GICs, on the other hand, are very easy to purchase

and require no research

because they are backed by the CDIC,

a crown corporation responsible

for ensuring banking deposits when purchased properly.

For the remainder of this video,

we will compare GICs and bond funds.

GICs are excellent for meeting a known expense

at a known future date.

If you know that you want to buy a new car

in exactly two years,

and you have the cash available today,

you might buy a two-year GIC.

This will allow you to earn a reasonable amount of interest

without taking on any risk

that the cash won't be there when you need it.

For longer-term goals

that are less certain in timing and magnitude,

like saving for and then eventually funding your retirement,

the attraction of a principal guaranteed

diminishes substantially.

For example, when a retiree

with a GIC letter has a GIC mature,

they will likely buy another GIC to replace it.

This ends up being exactly the same thing

that is happening inside of a bond fund.

Other than the psychological pleasure

of having your GIC principal returned unscathed,

as opposed to watching your bond fund fluctuate,

you have not gained or lost anything

by owning a GIC instead of a bond fund.

Let's walk through what I'm talking about.

If you own XSB, the iShares short-term bond fund,

you have a weighted average maturity of 2.86 years,

a yield to maturity of 2.71 percent,

and an effective duration of 2.7 years.

You can think about duration

as the amount of time that it would take you

to recover your losses resulting

from a one percent rise in interest rates,

assuming a parallel shift in the yield curve.

Let's say you could alternatively buy

a three-year compound GIC

with the same yield of 2.7 percent.

If interest rates rise one percent,

your bond portfolio will take a hit of about 2.7 percent,

while your GIC does not change in price.

However, the bond fund

will immediately be reinvesting coupons and maturities

into new bonds issued at now higher yields.

It's kind of like dollar-cost averaging.

Your total return over 2.7 years

should be relatively unaffected all else equal.

Your GIC, on the other hand, would not change in price,

but you would also not be immediately investing

at the now higher yields until your GIC matures.

If interest rates rise,

the economic value of the future interest payments

from a given GIC are reduced.

While you do not see a paper loss in your account,

you're missing out on higher interest

until your GIC matures.

The end result in both cases is about the same

in an economic sense,

with the big difference being in the psychology

of daily pricing for a bond fund.

You actually have to watch the economic loss happen.

One important thing to remember about the bond fund, though,

is that while with all else equal

you would expect to earn the yield

to maturity at the time of purchase

if you hold the fund for a period equal to its duration,

you should not expect all else to be equal.

Bond total returns are not only affected by interest rates.

They are also affected by credit spreads

and the shape of the yield curve.

We have already talked about the ultimate sources

of long-term bond returns, principal, interest payments,

and reinvested interest payments.

Similar to stocks, there are known factors

that explain the difference in returns

between diversified bond portfolios.

These factors are term,

where longer term bonds have higher expected returns,

and credit, where lower credit bonds

have higher expected returns.

GICs are only CDIC insured up to five years.

So in a prudent portfolio

they will typically be a short maturity holding,

which means that they miss out on the term premium.

The term premium has been substantial over time,

with the caveat that for maturities over 10 years,

the risk return trade-off becomes relatively unattractive.

In any case, we can compare the returns

of a short-term Canadian bond index,

representative of what we might expect

from a five-year GIC,

to an aggregate bond index,

representative of what we might expect

from something like ZAG, the BMO Aggregate Bond Index ETF.

Going back to 1985, which is where my data starts,

we see an annualized return of 6.51 percent per year

for short term bonds,

and 7.97 percent per year for the aggregate bond universe.

Keeping in mind that short-term bonds

are included in the universe,

you can see how much the mid and longer-term bonds

bring up the average return.

To be clear, this period does capture the extent

of the greatest bull market in bond history

due to falling interest rates.

However, we would still expect the relationship

between longer maturities, which are riskier,

and shorter maturities, which are safer,

to hold true over time.

Risk and return should always be related

in diversified portfolios.

The fact that GICs are CDIC insured is interesting.

The highest yielding GICs are often issued

by relatively risky borrowers,

so the yields are high due to credit risk,

but the CDIC coverage makes them risk-free to the investor.

It's almost like a government subsidized

arbitrage opportunity.

The risk-free credit exposure

is an attractive characteristic of GICs

that is not shared by bond funds.

So far, the most attractive characteristic of GICs

is that they don't look scary when rates rise,

but we've established that as not a real economic benefit.

We've also established that GICs miss out

on the term premium,

which has been substantial over time.

This point is not a knock against GICs.

GICs could reasonably make up

part of the shorter-term fixed income allocation

in a diversified portfolio.

There are a few more important characteristics to consider.

As I mentioned earlier,

GICs cannot be sold on the open market.

This means that they are illiquid.

Their illiquidity may contribute

to their relatively attractive returns

compared to short-term bonds,

but it also causes an issue in managing in your portfolio.

If stocks fall in price,

you may need to sell some of your bonds to buy more stocks.

This act of rebalancing becomes problematic

if all of your fixed income is in illiquid GICs.

Based on this, you would want to hold

at least some bond funds alongside your GICs for liquidity.

The majority of investors in Canada

have a massive home bias in their fixed income allocations

Canadians on average get around 90 percent

of their bond exposure from Canadian bonds,

while the Canadian bond market makes up

only about two percent of the global bond market.

In the past, there has been a good reason for this.

You do not want to own bonds in other currencies.

The volatility of currencies far outweighs

the volatility of bonds.

Owning a bond that is priced and pays interest

in a different currency might end up behaving

more like a stock in your investment account,

but without the higher expected return.

When global bond exposure

is hedged back to Canadian dollars,

there is without question

a diversification benefit to be gained,

mostly due to interest rate diversification.

Local risk factors like inflation, economic shocks,

and central bank policy generally result

in less than perfect correlations

in interest rates globally.

In a 2013 paper from Vanguard,

it was demonstrated that a hedged global bond portfolio

would have produced a better outcome

than an investors local bond market

in the majority of rising rate periods across Australia,

Canada, Europe, Japan, Switzerland,

the UK, and the US going back to 1995.

Thinking about this practically,

it just means that interest rates

in every country around the world

are unlikely to rise the same magnitude at the same time,

which should offer a diversification benefit.

That diversification benefit does show up in the data.

We can observe it for a Canadian investor

by comparing the FTSE TMX Canada Universe Bond Index

to the Bloomberg Barclays Global Aggregate Bond Index

hedged to Canadian dollars.

I have data going back to February 1999.

From that date through December 2017,

Canadian bonds returned to 5.26 percent,

with a standard deviation of 3.66 percent,

while global bonds hedged to Canadian dollars

returned 4.85 percent,

with a much lower standard deviation of 2.72 percent.

Keeping in mind that the goal of fixed income

is to reduce portfolio volatility, the similar return

and significantly lower standard deviation

of global bonds hedged to Canadian dollars is attractive.

Until 2014 ,there were not any low-cost

global bond index funds hedged to Canadian dollars

available to DIY investors.

As of now, Vanguard does have VBG and VBU,

which together offer access to the global bond market

hedged to Canadian dollars.

These are the funds used for bond exposure

in Vanguard's asset allocation ETFs.

It may feel like we've gone down a bit of a rabbit hole

on global bond diversification here,

but it ties back to our main topic.

GICs do not offer exposure to the global bond market.

Every dollar added to a GIC

is a dollar that cannot be allocated to global bonds.

With that said, in a 2018 paper from Vanguard,

it was demonstrated that adding currency

hedged to global bonds to a portfolio

has a meaningful but decreasing effect

on volatility reduction,

as the allocation to global bonds increases.

In other words, as long as you allocate some

to currency hedged global bonds,

you do not need to have your whole fixed income allocation

in currency hedged global bonds

to get most of the volatility reduction benefit.

I need to touch on tax efficiency.

When interest rates fall, bond prices rise

such that their yield to maturity matches the market.

Bonds always mature at par.

This means that if you buy a bond issued at $1,000,

for $1,100 after rates fall,

you will only get $1,000 back when the bond matures.

Now, over the life of the bond,

you will also get interest payments at above market rates,

such that the combination of above market interest

and the capital loss at maturity will give you

the yield to maturity that you would expect to earn

based on market rates.

Before taxes are considered,

you end up in the exact same position

as someone who bought their bond at par

and earned market rate interest until maturity.

The problem for a taxable investor holding a premium bond

is that you were receiving interest payments

at above market levels,

and then incurring a capital loss

to arrive at your yield to maturity.

The heavier weight and interest

results in more tax owing, with nothing gained.

A GIC will never suffer from this issue

because you cannot buy a GIC

that has gone up in price on the secondary market.

GICs are always at par.

This can make GICs relatively attractive

on an after-tax basis in taxable accounts,

under certain conditions.

However, there are also fixed income funds,

like ZDB from BMO, which avoid holding

tax-inefficient premium bonds.

The premium bond issue is not permanent.

If interest rates stay the same forever,

bond yield to maturity and average coupon

will end up being the same.

It is only when we have long periods of falling rates

that premium become problematic.

Let's quickly recap.

Total return is all that matters.

Whether your bond fund drops in value

or you earn below market interest

while you wait for a GIC to mature,

the economic effect is the same,

but GICs might help you sleep better.

GICs miss out on most of the term premium,

but they could fit into the short-term fixed income portion

of a diversified portfolio.

GICs are illiquid, so if they are used,

they should be used alongside bond funds for liquidity.

GICs miss out on global diversification,

but you don't really need your whole fixed income allocation

to consist of globally diversified currency

hedged fixed income anyway, as long as you have some.

Finally, GICs can offer attractive after-tax returns

in a falling rate environment

because they sidestep the premium bond issue altogether,

but this benefit is time period specific.

That was a pretty deep dive into fixed income.

I do hope it was still interesting.

In the end, I do not think

that there is an objectively right answer

on the question of bond funds versus GICs.

Both have advantages in certain situations,

but I think that it mostly comes down to preference.

If having a GIC ladder as part of your retirement portfolio

helps you sleep at night, I see no problem with that.

My preference is bond funds

for their diversification, better exposure to the factors

that explain fixed income returns, and liquidity.

If I had bonds in my portfolio, that is what I would own.

Do you prefer bond funds, GICs, or a combination of the two?

Tell me about it in the comments.

Thanks for watching.

My name is Ben Felix of PWL Capital

and this is Common Sense Investing.

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