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The Most Boring Battle Ever: Bond ETFs or GICs?

December 13, 2017 - 14 comments

If ever there were a contest held for “Canada’s Most Boring Investment Ever,” I’ll bet that bond ETFs and guaranteed investment certificates (GICs) would duke it out in the final round. We buy them to offset our more glamorous (and more risky) stock funds with some sensible dependability. Then, thankless crowd that we are, we cringe at their related paltry returns. 

So in the boring battle between them, which should you use? Laugh at the humble GIC if you must, but even though they’ve been around before many of you were born, GICs may just help save the day in today’s fixed income markets … and will probably outlive you while they’re at it. 

Consider this. Between September 30, 2016 and September 29, 2017, the 10-year Government of Canada benchmark bond yield rose from 1% to 2.1%. As the yield increased, prices dropped; Canadian bonds suffered their worst 1-year performance in over 20 years, losing nearly 3% of their value. 

Now, relative to the gut-wrenching double-digit drops we periodically see in the stock markets (50% during the last severe bear market), 3% doesn’t sound so bad. But many index investors just can’t stomach seeing their “safe” bond ETF holdings show up in bright red when they view their accounts. If fixed income is going to be so boring, they reason, the least it can do is keep its head above water.  

If this sounds like you, GICs may be worth a second look.

Bond ETFs vs. GICs

With a bond ETF, the best estimate we have of its future return is its weighted average yield-to-maturity (YTM). These days, the YTM on Canadian bond ETFs is about 2.34% (see image below). At 10.28 years, the weighted average maturity of the underlying bonds is also higher than you may prefer. This seems like a long time to expose your cash to a little more risk, while receiving so little extra in return. 

Enter the good old GIC. Not only does the Canada Deposit Insurance Corporation (CDIC) insure GICs within specified limits, many GICs have yields that rival those of your favourite bond ETFs, with a much lower average maturity. In fact, a 1–5 year GIC ladder at RBC Direct Investing currently boasts an identical average yield of 2.34%, with an average maturity of just 3 years (see image below). 

So with the GIC ladder, you could currently get the same expected return with far less term risk. 

Portfolio Characteristics of the iShares Canadian Universe Bond Index ETF (XBB)

Source: BlackRock Canada as of December 7, 2017

 

Top GIC Rates: RBC Direct Investing

Source: RBC Direct Investing as of December 8, 2017

 

Striking a balance 

The downside of GICs is that you generally can’t sell or liquidate them until they’re due. This can be an issue if you are trying to rebalance your portfolio back to its target asset mix after your equities tank. 

You can mitigate this liquidity risk by holding a combination of GICs and bond ETFs. As a rule of thumb, I tend to hold enough of the portfolio in bond ETFs to be able to rebalance back to my target asset mix even if there’s a 50% stock market meltdown. This rule is a bit confusing, so my cheat sheet below provides the suggested portfolio allocation between liquid bond ETFs and illiquid GICs.

Model ETF Portfolio Portfolio Allocation to Bond ETFs (%) Portfolio Allocation to 1–5 Year Laddered GICs (%)
20% stocks / 80% bonds 8.0% 72.0%
30% stocks / 70% bonds 10.5% 59.5%
40% stocks / 60% bonds 12.0% 48.0%
50% stocks / 50% bonds 12.5% 37.5%
60% stocks / 40% bonds 12.0% 28.0%
70% stocks / 30% bonds 10.5% 19.5%
80% stocks / 20% bonds 8.0% 12.0%

 

Rebalancing act

Let’s work through an example together, adapting my model ETF portfolios to include GICs. Suppose you have a $100,000 portfolio, with a target asset mix of 60% equities and 40% fixed income. (So you would initially have $60,000 in equities and $40,000 in fixed income.) If your equities dropped by 50%, they would be worth $30,000 while your fixed income would still be at $40,000, for a total portfolio value of $70,000. To rebalance the portfolio back to its 60/40 target asset mix, you would need to sell $12,000 of bonds and purchase $12,000 of equities ($70,000 new portfolio value × 60% target equity asset mix = $42,000 minus $30,000 of existing equities = $12,000 of additional equities required). 

So for an initial portfolio value of $100,000, you would allocate $12,000 to bond ETFs (or 12%); the remaining $28,000 (or 28%) could be invested in GICs, with $5,600, or 5.6%, invested in each GIC rung.

Example: Portfolio rebalancing using GICs and bond ETFs

Security Before the 50% stock market downturn After the 50% stock market downturn (pre-rebalance) After the 50% stock market downturn (post-rebalance)
BMO Aggregate Bond Index ETF (ZAG) $12,000 $12,000 $0
1-Year GIC $5,600 $5,600 $5,600
2-Year GIC $5,600 $5,600 $5,600
3-Year GIC $5,600 $5,600 $5,600
4-Year GIC $5,600 $5,600 $5,600
5-Year GIC $5,600 $5,600 $5,600
Vanguard FTSE Canada All Cap Index ETF (VCN) $20,000 $10,000 $14,000
iShares Core (XUU) $20,000 $10,000 $14,000
iShares Core MSCI EAFE IMI Index ETF (XEF) $15,000 $7,500 $10,500
iShares Core MSCI Emerging Markets IMI Index ETF (XEC) $5,000 $2,500 $3,500
Total RRSP Account $100,000 $70,000 $70,000

 

This illustration also happens to facilitate another important point about the fixed income holdings we so often love to hate. When stock markets do periodically plummet, those “boring” bonds or GICs can suddenly become your best friends. Imagine if your $100,000 portfolio were all-equity, and had plummeted to $50,000 instead of $70,000. You’d probably rue the day you ruled out tempering your stock market risks with some sturdier (if less stellar) GICs or bonds. 

So, will you opt for simpler, single bond ETFs, or mix in some GICs as well? Let me know what you think. Either way, in markets fair and foul, give your fixed income investments a little more love. They’ve earned it. 

By: Justin Bender with 14 comments.
Comments
  02/03/2018 9:57:33 AM
Justin Bender
@Malcolm: When you buy an individual bond that is trading at a premium to its par value (or a basket of premium bonds in a mutual or ETF structure), you will receive additional interest to compensate you for the capital loss realized when the bond matures at its lower par value. However, in taxable accounts, premium bonds can be very tax-inefficient (so you should only hold bonds or bond ETFs that are structured for taxable accounts).
 
  28/02/2018 2:26:51 PM
Malcolm
I've been using a mixture of GICs and 5 year laddered bonds for a few years. Been using the Bonds in preference to Mutual Funds due to the costs of MF's. However, the Bonds are always over the par value, so when you sell at maturity, you loose. Am I doing good or bad ?
 
  17/01/2018 9:46:37 AM
Justin Bender
@Cat: Unfortunately, I do not calculate customized money-weighted performance figures for readers (I would be bombarded with requests! ;)
It seems as though it’s a very short investment period for making long-term decisions. The yield-to-maturity on ZDB is roughly equivalent to the expected inflation rate (before taxes).
 
  11/01/2018 2:00:24 AM
Cat
Thanks Justin! I should have been more specific in my timeline. I purchased the ZDB fund back in September & October 2016 and February 2017, all in equal amounts. As how i calculated it, there seems to be a loss even with the income received. Can you confirm this for me?

I will keep in mind that the bonds are there to provide portfolio stability but it would be awesome if it could keep up with inflation.
 
  10/01/2018 1:29:04 PM
Justin Bender
@Catherine: Just to clarify, ZDB had an average return of 1.54% over the past 2 years – sometimes investors see the capital loss on their bond ETF holdings and forget about the interest they have received from the fund over the past 2 years.
 
  08/01/2018 3:09:33 PM
Justin Bender
@Nick: Most investors are uncomfortable with a 100% equity allocation (and depending on their individual situation, they may not need to take that much risk). While it’s theoretically true that investors with defined benefit pension plans can take more risk with their investments, it is also true that they generally don’t need to take as much risk (as they have a guaranteed income for life). I would recommend going through the financial planning process with your advisor or a fee-only financial planner to determine how much risk you need to take.
 
  08/01/2018 3:08:54 PM
Justin Bender
@Curious: Our clients’ investments are held with National Bank Independent Network (NBIN). NBIN currently offers GICs from 25 different issuers that we can purchase in our client accounts (so a single CDIC insured account could technically have up to $2,500,000 of GICs if we spread them across all of the available issuers). This means that you could have a balanced 60EQ/40FI portfolio (of only a single insured account type) worth $8,928,571 (with a 28% allocation to GICs) before hitting the limits ($2,500,000 ÷ 0.28). If you start doubling up on issuers by purchasing GICs in other insured account types (like RRSPs), the portfolio could be even larger.
 
  08/01/2018 2:28:02 AM
catherine
Thank you for posting this. I am in the process of trying to figure out what I can replace with the bmo discount fund which has been doing poorly for the past 2 years since my purchase. I have started putting some in HISA and now, will try to do this bond ladder for 2018. Thank you for helping us make smarter choices!
 
  03/01/2018 10:55:42 AM
Justin Bender
@Mike Menicanin: ZAG’s 0.14% MER figure is as of December 31, 2016. On June 22, 2016, BMO reduced the management fee of ZAG from 0.20% to 0.09% (so the 0.14% figure is basically a weighted average of the two figures).

ZAG’s management report of fund performance as of June 30, 2017 shows an MER of 0.10%: https://www.bmo.com/assets/pdfs/gam/etf/en/sa_mrfp_ZAG_e.pdf

After their 2017 year-end reports have been released, BMO are expected to update the posted MER on their website to roughly 0.10%.
 
  01/01/2018 4:34:50 PM
Curious
Justin, thanks for your link. However, I still wonder how you counsel high-income individuals.
Say, according to your example, if your client had $1 million dollars instead of $100,000 and wanted to keep 40% in bonds, that would be 10x your amount in the article, or $280,000. You would need at least three different accounts to be insured.
And if they had $2 million, you would need six different accounts. What would you do, if you don't mind me asking? Thanks so much.
 
  30/12/2017 2:34:06 PM
Nick
Hi Justin

I have a defined pension with omers which will pay me enough, my wife also has a federal pension, I want to change my tfsa allocation to all stocks do you see any problem with this allocation

VCN-25%
XUU-25%
XEF-25%
XEC-25%

all equal across all indexes simple and easy, your thoughts

Nick
 
  27/12/2017 10:37:10 AM
Justin Bender
@Curious: CDIC insures eligible deposits SEPARATELY (up to $100,000, including principal and interest) for EACH of their seven account categories: http://www.cdic.ca/en/about-di/how-it-works/Pages/default.aspx

As long as you’re careful to play by CDIC’s rules, I don’t see any issues with holding the same issuer in different account categories.

As you noted, some investors prefer to shop around for high interest savings cash accounts instead of purchasing GICs (such as at EQ Bank). Again, I don’t see any issues with this, as long as you stick to the CDIC thresholds.
 
  23/12/2017 1:42:50 PM
Mike Menicanin
Hi Justin. Thanks for your ongoing DIY investing insights. PWL and the Couch Potato have been helpful in making our family's long term savings effective. My question concerns Bond ETF fees. Model portfolios favour ZAG as the low cost leader but my research shows ZAG's .14 MER vs. VAB's lower MER of .13. While ZAG's Management Fee (.09) is lower than VAB's (.12), I thought the MER reflects the investment cost of an ETF. Am I missing something about the cost of owning VAB vs. ZAG ?
 
  14/12/2017 11:01:59 PM
Curious
Hi Justin,
Your and Dan's model portfolios show the long-term math is behind bonds, so thanks for that.
For GIC's, what about the $100,000 insurance limit? Do you have advice about spreading it to taxable vs. non-taxable accounts, i.e. trying to spread GIC's into corporate accounts, RRSP, or TFSA?
Millennial Revolution has also pointed out that you can switch between High Interest Savings Accounts in lieu of GIC's. Do you have any thoughts on that?
Thanks for these thorough blogs.
 



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