Depending on how you use them, GICs are not without risks. We consider their nominal and real returns and contrast using GICs for savings with reducing a mortgage.
The Guaranteed Investment Certificate (GIC) is a loan to a financial institution such as a bank or credit union. A lump sum is lent for a fixed period, typically 1-5 years. Interest payments can be monthly, annually or accumulate to the end of the loan period. GICs cannot be sold before maturity except under special circumstances. There are multiple sources of information on GICs from issuers and here.
We review the historical performance of GICs and consider their utility for investors. A GIC differs from a bond or stock in that the future price is known so the return is determined by the yield when purchased. For example, a $1000 investment in a 1-year GIC with an annual payout, with a yield of 3%, would result in a payment of $1030 when it matures at the end of the year. The investment return is 3%.
The chart below shows the historical return from a 1-year and 5-year GIC for the period May 2007 to June 2022. The Bank of Canada policy rate is also shown, which is the target set by the Bank of Canada for banks to lend money to each other overnight to settle the transactions of daily banking. If the Bank of Canada raises this rate, then banks typically increase their lending rates, such as mortgage rates. The difference between their (long term) lending and their (short term) borrowing impacts a banks profits, so to stay competitive a rise in policy rate leads to a rise in savings rates, including GIC rates.
We observe:
The purpose of investing is to match future expenditure. The expenditure could be short term (a mortgage payment) or long term (retirement spending). If the focus is on future spending, the concern should be the purchasing power in the future economy. The purchasing power of an investment is eroded by inflation: if the price of a loaf of bread doubles over the next 10 years, then your investments should at least double over the same period to buy the same number of loaves in ten years than you can today. We distinguish between the nominal return of an investment (the dollar value) and the real return (the purchasing power, accounting for inflation). To a good approximation, the real return is the nominal return less inflation.
How effective are GICs at protecting purchasing power? The chart below shows the same data for 1-year and 5-year GICs as the previous chart adjusted for inflation. To produce the chart below, we reduced the GIC yield in the chart above by the rate of inflation whenever the yield changed. The rate of inflation is the increase in prices over the past year and is thus backwards looking. The assumption in our chart is that inflation will continue at the same rate for the duration of the GIC. Predicting future inflation even one year ahead is notoriously difficult: recent inflation forecasts have lagged actual inflation. GICs are often promoted as risk free investments but in periods of rapidly changing inflation the real return from GICs is risky if the goal is preserving purchasing power.
Historically, real return’s from GICs have done best when inflation is falling and worst when it is rising. The recent real return from GICs is the lowest over the 15-year period.
As with any investment, GIC purchases should be considered alongside other options. We consider some familiar examples:
The investor who is personally risk averse may opt for the least bad option. Even though this may mean a loss of purchasing power, the investor may be more comfortable with the risk associated with future inflation (i.e. when the GIC matures) than the risks associated with exposure to the stock and bond markets.
For retirement we want to at least preserve purchasing power, so the focus is on real returns. We are currently in a period of high inflation and rising interest rates. Commentators express concern about a recession, often with the unstated implication that this would be more bad news for the stock market. This misunderstands the nature of the stock market as a leading indicator of the future economy not the converse. Nevertheless, markets are much more volatile than if they were driven by rational expectations so short-term actual returns are dominated by noise or unexpected events. Is it worth enduring a small but certain decline in purchasing power for a while in the hope of avoiding something worse? What are the chances that investing in a GIC and rolling over the proceeds out-performs a balanced portfolio? To evaluate, we compare the time weighted average 1-year and 5-year real GIC returns with a balanced portfolio of 60% stocks and 40% bonds.
| Investment | 1-year real return | 5-year compound real return | 10-year compound real return | 20-year compound real return |
|---|---|---|---|---|
| 1-year GIC | 0.0127% | 0.064% | 0.127% | 0.255% |
| 5-year GIC | 0.8181% | 4.158% | 8.489% | 17.699% |
Based on these numbers, $1,000 invested in 1-year GICs for 10 years would be worth $1,001.27 (in today’s dollars). A balanced portfolio, as we have experienced in recent months, can experience negative returns. We estimate the probability that the GICS will out-perform a balanced portfolio over a period of 1, 5 or 10 and 20 years in the table below.
| Investment | 1 year | 5 years | 10 years | 20 years |
|---|---|---|---|---|
| 1-year GIC | 32.90% | 16.40% | 10.20% | 2.80% |
| 5-year GIC | 36.00% | 24.30% | 16.70% | 6.50% |
Over 10 years, for example, a 1-year GIC has a 10.20% likelihood of outperforming a balanced portfolio. For investors in the current environment who want to adopt a “wait and see” approach and put away cash for a year then odds are less than 50% of success but, as noted above, this may be acceptable to investors who want to avoid the small possibility of a large loss. The caveat is that those investors should consider whether their risk aversion is being driven by short term fears from the news media or is a longer-term reflection of their risk aversion and whether they can reach their financial goals without exposure to market risk.
Education savings using a Registered Education Savings Plan (RESP) have an investment horizon of typically 0-20 years and investments are tax sheltered within the plan. The size and timing of the liability, in the form of school fees, is largely predictable. As the child gets within 5 years of school using GICs to match the fee schedule becomes an attractive way of avoiding the risk of a funding shortfall.
If you have, for example, $10,000 in spare cash should you buy a GIC or reduce the mortgage? Paying off debt is equivalent to owning a tax free GIC. Consider the example below:
| Option | Interest Rate/Mortgage rate | Initial Value | Interest Gained | Interest Gained ( after-tax) |
|---|---|---|---|---|
| Invest in GIC | 3.75% | $10,000 | $2,021 | $1,415 |
| Reduce Mortgage (5-year term) | 4.85% | $10,000 | $2,542.37 | $2,542.37 |
| Reduce mortgage (20- year term) | 4.85% | $10,000 | $2,693.35 | $2,293.35 |
The first option is to invest in a 5-year GIC paying 3.75% interest (Tangerine, 23 June 2022) paying $12,021 at maturity. If the interest is taxable income and assuming a 30% tax rate, the after-tax value is $11,415, or after-tax interest of $1,415.
The second option is to use the $10,000 to reduce a mortgage which charges interest of 4.85% (TD, 23 June 2022). Because fixed rate mortgages are compounded semi-annually, this equates to an effective annual rate of 4.91%. Reducing the mortgage avoids interest payments over the amortization period of the mortgage. We assume an open mortgage with no prepayment penalty where we make a prepayment rather than re-mortgage. If a $100,000 mortgage has a term of 5 years, the balance after 5 years is zero and the total interest payment is reduced by $2,242.37.
If the mortgage amortization period is 20 years, the total interest payment is reduced by $2,693.35 over the first 5 years and $14,388.77 over the life of the mortgage.
In this example reducing the mortgage is better than investing in a 5-year GIC. Generally, mortgage rates are higher than GIC rates at any instant, but If you are fortunate enough to be able to access a GIC rate higher than your existing mortgage rate this may change the outcome. Individual circumstances will vary due to fees, taxes, changing GIC rates and changing mortgage rates.
After fees, real returns from rolling over-short term GICs are approximately zero. This should not be surprising given their low risk of default. This may be acceptable to a risk averse investor who has sufficient capital to reach their financial goals without taking market risk. For other investors, GICs can have a useful role in meeting short term liabilities but similar or better results may be achieved by reducing debt.
