GIC Time?

Let me make one point clear at the outset. I am not a fan of guaranteed investment certificates (GICs). In most circumstances, I believe there are much better places for your money.

But, as the Bible says, “to everything there is a season.” The season for GICs may have come.

I say this because the sudden spike in interest rates has created widespread uncertainty in both the stock and bond markets, leaving investors unsure of what to do next. Craig Alexander, chief economist of TD Bank, says we are in “uncharted territory.” He’s right. Never before have governments around the world unleashed such massive stimulus programs. Now we’re about to begin the winding-down phase and no one knows how that will play out.

The initial consequence has been a spike in bond interest rates of a magnitude that has shocked even veteran economists. At the start of this year, the yield on 10-year U.S. treasuries was 1.76%. On June 24 they closed at 2.54%. That’s an increase of 44% in less than six months, which is almost unheard of.

The effect on bond prices has been devastating. The DEX Universe Bond Index is down 2.07% year-to-date as I write. Corporate and high-yield bonds have held up reasonably well but government issues have been hit hard. Real return bonds have been savaged by the combination of rising rates and low inflation; year-to-date the DEX Real Return Bond Index has lost 12%.

The jump in rates has also taken its toll on interest-sensitive stocks. The S&P/TSX Capped REIT Index lost more than 11% in June (to June 25) while the Utilities Index was down almost 10%. This means the “safe” defensive securities that have been the cornerstone of many income portfolios are being battered.

A strong argument can be made that the sell-off has been overdone. But that does little to calm investors who have seen a large chunk of their capital melt away and are worried there may be more damage to come. Hence the renewed interest in GICs.

There are valid reasons to consider putting some money into GICs right now. For starters, market risk is eliminated. GICs do not fluctuate in value, except in the very small secondary market. They guarantee that your money will be returned with interest at maturity and they are protected by deposit insurance up to $100,000 per financial institution.

One of the traditional arguments against GICs is much of the profit gets eaten up by inflation. But the inflation rate right now is very low – only 0.7% in May, according to Statistics Canada. In the U.S., the Federal Reserve Board is still worried about the possibility of disinflation – negative inflation – according to comments made last week by Chairman Ben Bernanke.

High taxes are another GIC downside – interest income is taxed at your marginal rate. However, if the certificates are held in a registered plan such as a TFSA or RRSP, that concern is eliminated.

The problem is although the banks have started to raise mortgage rates, we still haven’t seen much movement on the GIC side. A five-year non-redeemable GIC at Royal Bank paid only 2.2% at the time of writing and the other big banks are around the same range. You can get as much as 3.15% at a smaller institution such as ICICI Bank (the Canadian subsidiary of a large Indian bank). That’s not a lot, but if you keep it in a registered plan, your real return after inflation would be 2.45%. Some people might see that as a reasonable payoff given the safety that GICs provide.

However, before you make the decision consider this. If we are indeed moving into a period of rising interest rates – and the jury is still out on that – GICs will be offering better yields in the coming months. However, by investing now you won’t be able to take advantage of them because your money will be tied up until maturity. There are some ways to avoid this trap, however.

Go for a shorter term. Instead of the usual five-year term, opt for a shorter maturity. Your interest rate will be lower but you’ll be able to reinvest sooner, probably at a higher rate. According to Globe Investor, ICICI Bank is offering 2.4% for a two-year GIC right now, which seems like a reasonable compromise in the circumstances.

Choose a redeemable GIC. Many financial institutions offer GICs that can be cashed in at any time. However, the interest rates are usually lower and there may be hefty penalties for early termination. Check out the details before making a commitment.

Use a GIC ladder. I’ve written about the use of bond and GIC ladders in the past. This involves dividing your money into several baskets (say five) and investing in GICs of varying maturities from one to five years. As each GIC matures, roll it into a new five-year term. That way, you’ll be able to take advantage of rising rates.

Use a high-interest savings account. If you want both safety and maximum flexibility, forget about GICs for the time being and use a high-interest savings account. However, stay away from the big bank offerings – they only pay about 0.5%. Check out the smaller companies. ING Direct (now owned by Scotiabank) is offering 1.35% on their Investment Savings Account and 1.4% in a TFSA. President’s Choice Financial, which is affiliated with CIBC, offers the same deal. Both are covered by CDIC.

In making your decisions, keep in mind that what we have seen was a knee-jerk action to the Fed’s announcement that it may begin scaling back its quantitative easing (QE) program later this year. Much will depend on the speed of the economic recovery and there are still many question marks on that score.

Once the situation settles down, we could see a pull-back in bond yields – that would not be a surprise given the speed at which they rose. That in turn would boost the prices of bonds and interest-sensitive securities.

As Mr. Alexander said, we’re in uncharted territory. It’s important to stay on top of your portfolio and be flexible. Taking some profits and building cash reserves is always a good strategy in such times. Review all your options carefully.

This article originally appeared in The Income Investor newsletter. For details on a three-month trial subscription (six issues), please visit www.buildingwealth.ca