Bonds vs GICs

This piece was originally published on February 2, 2023 and has been updated as of November 22, 2023.

Typically, bonds play two key roles in a portfolio. First, they act as a source of income through their coupon payments. And second, historically, they‘ve provided downside protection for a balanced portfolio. Normally, when equities have sold off, bonds have softened the blow. However, this hasn’t been the case in recent history. In 2022, for example, investors experienced a rare occurrence when bonds and equities both fell. In 2023, bonds have again not behaved how you might expect.

Despite inflation levels in the United States and Canada being halved so far in 2023, yields across fixed-income asset classes have moved higher. The U.S. and Canadian 10-year government bond yields have increased by 1.0% and 0.8%, respectively. Since bond yields and prices move in opposite directions, bond returns have suffered.

Why did interest rates move higher and will it continue?

There are many factors that influence the path of interest rates. We believe that these are just some of the reasons that the U.S. 10-year Treasury yield has hit levels not seen since before the Global Financial Crisis.

Resilient economy

Despite data that would suggest otherwise, economic activity has remained resilient mostly on the backs of consumer spending. The bond market had expected a weaker path for the U.S. economy—and because the 10-year yield tends to move in the same direction of economic expectations, when the data surprised to the upside, the market moved yields higher.

Political uncertainty

The current political environment in the U.S. has made compromise quite difficult. During the summer, the uncertainty around raising the debt ceiling and the eventual need for additional debt resulted in Fitch Ratings, a credit rating agency, downgrading the U.S. Treasury debt rating to AA+ from AAA. More recently, the fear of a government shutdown has led to speculation that Moody’s, another credit rating agency, will also cut the rating below AAA. This resulted in a decrease in price of the U.S. 10-year Treasury and, therefore, an increase in yields.

Supply-and-demand imbalance

Recently, historically large investors of U.S. treasuries, such as foreign pension plans and sovereign wealth funds (SWFs), have reduced their exposure to U.S. Treasuries. The U.S. Federal Reserve has also reduced their bond buying, removing another typical buyer of bonds. This happened at the same time as the U.S. will likely need to increase its supply of government debt to fund spending.

While these factors have led to higher yields, our expectation is that the economy will likely weaken from current levels. We believe it’ll be harder for the consumer to carry the economic load with depleted savings, in addition to elevated levels of credit card debt and higher cost of carrying that debt. If the economy does weaken, we’re likely going to see lower bond yields and improved bond performance.

GIC yields are attractive—are they better than bonds?

A silver lining to the past couple of years’ increase in interest rates is that bonds and guaranteed investment certificates (GICs) are now offering very attractive yields. Many investors are even questioning whether they’re better off investing in GICs rather than bonds, given that the yields are comparable.

While the safety of a GIC might make sense for investors with an investment time horizon of less than a year, for those investors with a longer one, we tend to caution using GICs as an alternative to bonds in a balanced portfolio for three main reasons:

• Canadian bonds have typically outperformed GICs.
• The outperformance of bonds vs GICs has typically been material.
• There’s potential reinvestment risk for GIC investors.

Canadian bonds have typically outperformed GICs

Since the creation of the FTSE Canada Universe Bond Index, Canadian bonds have outperformed GICs nearly 73% and 90% of the time on a one-year and three-year rolling basis (Bloomberg). Typically, when investors compare GICs to bonds, they only compare the current GIC rate to the bond yield. While this may be a good comparison for the income generated, it leaves out one material aspect: the potential for the bonds to appreciate in price while GICs can’t.

The inverse correlation between bonds and interest rates that were a headwind to bond returns over the past couple of years can be a tailwind moving forward. Measures of inflation that we follow indicate that inflation has peaked and may continue to trend lower. With the Bank of Canada having already paused the increase in their interest rate and potential cuts in line for 2024, this could provide a backdrop for a drop in yields and a price appreciation for bonds. We believe that the recent outperformance of GICs was a rare occurrence and we’ll likely revert to an environment where bonds outperform GICs.

Outperformance of bonds vs GICs has typically been material

The chart below illustrates that the difference in performance between Canadian bonds measured by the FTSE Canada Universe Bond Index and GICs is often material. For example, since its inception, 50% of the time, Canadian bonds have outperformed GICs by greater than 2.5% per year. In fact, nearly 30% of the time the difference is greater than 5%! With a yield of nearly 6% for Canadian investment-grade bonds and potential upside to prices in a falling interest-rate environment, it’s possible that the outperformance of bonds vs GICs could be material moving forward.

There’s potential reinvestment risk for long-term GIC investors

When GICs mature, investors have a decision to make with their money: either reinvest back into a GIC at the prevailing rate or invest in something else. Over the next few years, we believe interest rates are likely to be lower, possibly resulting in GIC rates much lower than those originally invested in. In fact, many longer-term GIC rates being offered are lower than they were only a few months ago. While the yield in bonds will also likely be lower, the investment opportunity set is much larger. Active fixed-income managers can allocate money to the better relative opportunity, be it in global government bonds, investment-grade corporate bonds, or even high-yield bonds.

Will bonds and GICs return to their historical performance?

The opportunity in bonds is arguably the best it has been in 15 years, going back to the Global Financial Crisis.

Investors tend to show recency bias, a behavioral response that takes recent performance (both good and bad) and expects it to continue. Investors might be comparing current GIC rates to the volatility and negative returns in bonds since 2022 and assume that’ll be the case moving forward. While yields could surprise to the upside from current levels, it’s likely that most of the move is done. There’s always the potential for an outlier event or for short-term swings in yields, which further points to the need for active management from a credit and duration perspective with bond investing.

We believe that a slowing global economy will continue to put downside pressure on inflation, leading to a decline in interest rates over the next few years and possibly resulting in a backdrop where bond returns revert to their more traditional outperformance relative to GICs.