It's indisputable that 2022 was an extremely challenging year for investors—particularly for those with more conservative fixed-income portfolios. Soaring inflation and the aggressive response from central banks by way of steep interest rate increases had not been seen in a generation. This provided a harsh reminder to investors that when interest rates go up, the value of bonds go down. 

The unexpected losses in the fixed-income market combined with attractive GIC rates have led to many investors opting for predictable and guaranteed returns. Though this is understandable, we believe that while GICs may be suitable for some, they are not the best solution in attaining the long-term goals of most investors. We’ll examine some advantages that bonds might have over GICs to help you determine which may make the most sense for your portfolio.

Why bonds?

The majority of investors looking at GICs right now are doing so because they want to earn the posted rate along with certainty that they’ll have their principal intact at maturity. Below, we’ll examine how bonds can provide this along with other potential advantages such as greater flexibility, potential tax efficiency and opportunity for higher yields.

Certainty

As we’ve seen, the increase in interest rates led to a decline in price for most investment-grade bond issues. Barring any defaults by the issuer—which is an extremely unlikely prospect for investment-grade corporates and essentially non-existent for government issues—a bond will mature at par, meaning the investor gets their money back. It’s important to remember that changing bond prices don’t matter much for investors holding the bond until maturity as they’ll be expected to be made whole when the bond matures. This is highlighted in the visual below.

So while GICs may feel considerably safer than bonds in the sense that they don’t exhibit any price fluctuations, any market declines caused by a changing rate environment can be recouped for a bond investor at maturity. Investors should also be aware that bonds with longer terms, such as 5 or 10 year bonds, may experience greater market price fluctuations as interest rates have more opportunity to fluctuate, but they are also recouped at maturity. Understanding this relationship may provide investors with the comfort to explore a bond in lieu of a GIC.

Flexibility

Bonds are generally liquid instruments that are easily bought and sold on the market. GICs on the other hand, tend to be locked in until maturity and, if the contract can be broken, often include significant penalties for doing so. This provides a bond holder with much more flexibility or liquidity should they wish to access their investment for either an unplanned expense, or to reallocate the proceeds to a better opportunity set.

The tradeoff is that a bond’s value fluctuates, as we highlighted above. It’s important to remember that bonds can also appreciate in value when rates—or expectations around future rates—decrease. In either case, if held until maturity, a high-quality bond should return its par value to the investor with a high degree of certainty.

Taxes

While taxes are not the only consideration in making an investment, they remain an important one. The returns for GICs consist entirely of their coupon payments and are categorized as interest income. When held in non-registered accounts, this is always taxed at the investor's marginal tax rate (MTR).

With a bond, the total return or yield consists of its coupon or interest payment as well as price appreciation. Any price appreciation is categorized as a capital gain which is taxed more favourably with 50 per cent being taxed at the investor’s MTR.

Over the last few years, the rising interest rate environment has led many previously issued bonds to decline in value—that is, they are trading at a discount to their par value. This means that an investor purchasing one of these bonds today would also receive a capital gain component if they held the bond to its maturity.

To illustrate, let's consider the below example which compares a GIC with a bond of a similar term and yield. The bond’s yield-to-maturity is the approximate sum of its 2.35 per cent coupon payments and its capital gains of 3.46 per cent coming from the bond gradually appreciating in value as it approaches its maturity date. The table below quantifies the favourable taxation attributed to the bond’s capital gain in terms of its after-tax return compared to the GIC.

In this example, despite a similar yield, the bond provided a much larger after-tax return for the investor holding a bond outside of a registered account.

Higher yields

A basic tenet of investing is that an investor should expect to be compensated for the risk they take. That is, if an investment carries a higher risk of loss it should be expected to generate higher returns as well. In the fixed-income world, the difference between the risk-free rate and the riskier security is known as the spread. In Canada, for investment-grade corporate bonds, this spread has ranged from roughly 0.4 to 0.9 per cent, as shown below.

A primary risk that a bond carries versus a GIC is the chance that the issuing company defaults on their debt. In reality, this has occurred less than 0.1 per cent of the time over the past 40 years for global investment grade corporate bonds.¹ An investor looking for a higher yield can pick up the spread and would appear well compensated for the ‘extra’ risk. This is a worthwhile consideration when selecting where to place your money.

Final thoughts

While yields on GICs can look attractive to investors right now, there are many high-quality bonds in the marketplace that offer competitive yields with a high degree of principal security. After considering the other benefits of owning a bond compared to a GIC, the case for doing so is strengthened—so long as an investor is comfortable with the notion of potential price fluctuations leading up to maturity. 

As we seem to be nearing the end of the business cycle with rates likely plateauing, the future return prospects of bonds look quite appealing. Every investor has different goals and preferences to consider regarding their investment decisions, and in some cases, a GIC may be the most appropriate. A better understanding of these two securities will allow investors to better determine the most suitable and appropriate investment for their portfolio.