To answer this question, we first need to understand the difference between a bond fund’s yield to maturity and the interest rate on a GIC. We then need to understand the relative tax efficiency of GICs compared to bond funds, and how it may impact after-tax returns.
The yield to maturity on a bond fund tells us the total return that an investor in the fund could expect if they held the fund for its average maturity. This number assumes that all else remains equal. In a live bond fund, though, changes in credit spreads and the shape of the yield curve might have meaningful effects on total return. These effects will show up as the capital portion of fixed income returns.
This is easy to observe in the past data using ZAG. In January 2014, ZAG had a yield to maturity of 2.46%. At that time we could have built a GIC ladder using the average brokerage GIC rate for 1 through 5-year GICs with an average rate of 2.04%, using GIC rates from National Bank Independent Network. A brokerage GIC is generally going to have a lower rate than what you would find going direct to an issuer, so let’s tack on an extra 35 bps* to estimate what you might have been able to find out in the wild. Now we are comparing a bond fund with a yield to maturity of 2.46% to a GIC ladder with a guaranteed first-year return of 2.39%. The argument to go with the GIC seems compelling if yield to maturity is a good proxy for future returns. However, that will not always be the case.
If we refresh our 5-year GIC ladder using the same average brokerage GIC rate + 35 bps for the next 5 years, the total pre-tax return for the GIC ladder will have been 2.60% per year, on average. The 5-year return for ZAG over the same period was 3.32% per year on average. This could have gone the other way, with bond returns trailing GIC returns, but given a long enough time frame we would expect the longer-term bonds in ZAG to deliver a risk premium.
| GIC Ladder | ZAG | |
| 5-Year Capital Return | 0.00% | 0.24% |
| 5-Year Income Return | 2.60% | 3.08% |
| 5-Year Total Return | 2.60% | 3.32% |
This takes us to the next point: tax efficiency. There is no question that tax efficiency is an important part of investing. Portfolio structure is another important part of investing. These two important aspects of investing will often be in conflict with each other. One of the criticisms of a bond fund like ZAG is that it contains premium bonds, which are tax inefficient. A premium bond pays a higher income yield which attracts more tax. The higher income is offset by a capital loss at maturity such that the premium bond has the same yield to maturity as a similar bond at par. This is true if all else is held equal, but other factors can affect the capital portion of returns. A GIC is always at par for tax purposes; it is not possible to have a premium GIC in your brokerage account.
We will walk through an example to illustrate the difference in after-tax returns. ZAG currently has a yield to maturity of 2.60% and an average coupon of 3.23%. Any time that we have a coupon that is higher than our yield to maturity, we have a premium bond. Let’s imagine that we could find an instrument issued at par with the same yield to maturity as ZAG. This instrument may well be a GIC, which, for tax purposes, will always be at par. All else equal, we would expect the difference in after-tax returns to be 0.14%. It is those 14 bps that we are worried about with the premium bonds.
This means that in a taxable account the after-tax returns of a GIC may be more efficient than the returns of a bond fund holding premium bonds. This is important, but it is important to remember that the premium bond issue not permanent. It is a problem that exists at a point in time. Basing long-term portfolio structure decisions on a non-permanent problem may not be optimal. The other problem is that increasing the tax efficiency of returns does not necessarily lead to higher after-tax returns. We can see this following our previous example into after-tax territory.
We will look again look at our simulated GIC ladder compared to ZAG. We saw that the pre-tax returns for ZAG were higher for the 5-years ending December 2018. Despite the premium bonds in ZAG, the after-tax returns were also higher. We see that the higher coupons were not offset by capital losses. The fund even had a capital gains component to its total return. The capital portion of fixed income returns is not as reliable as the income component, but it cannot be ignored. Over this time period it was a positive contributor to total returns.
The GIC ladder returned 1.25% per year on average after tax, assuming the highest marginal tax rate in Ontario in 2018 for the full 5-years. ZAG returned 1.80% per year on average after tax.
| GIC Ladder | ZAG | |
| 5-Year After-Tax Capital Return | 0.00% | 0.24% |
| 5-Year After-Tax Income Return | 1.25% | 1.56% |
| 5-Year After-Tax Total Return | 1.25% | 1.80% |
Now, this observation is most certainly time-period specific. There will undoubtedly be 5-year periods where bond funds underperform GICs. Over the long-term, though, the shorter term of GICs puts them at an expected returns disadvantage relative to an aggregate bond fund. Adding GICs alongside a bond fund is effectively a decision to increase the weight of shorter maturity fixed income in the portfolio with the intention of increasing tax efficiency. This trade-off between tax efficiency and portfolio structure is not necessarily obvious, as we can see from our example.
