The fixed income component of the Dimensional Fund Advisors global portfolios has been low to-date in 2018, and also for the past 12 months. It is down 0.51% year-to-date at July 2018, and down 0.27% for the 12 months ending July 2018.

Fixed income is typically the safe portion of a portfolio of risky assets. Fixed income is not held for the primary objective of maximizing returns, but for minimizing volatility through diversification. Fixed income assets tend to have imperfect correlation with stocks. This offers a buoy effect if stocks are falling. The opposite is also true; when stocks are doing well bonds do not tend to do as well. Similar to stocks, there are many sub asset classes within fixed income. These sub asset classes have different risk and return characteristics.

Fixed income factors

Some characteristics of fixed income have been identified as responsible for most of the asset class returns. The two factors that explain the majority of fixed income returns are term and credit; longer-term bonds and bonds with lower credit tend to have higher long-term returns. This is intuitive as each of these characteristics, term and credit, result in an asset that is riskier to hold. As always, risk and return are related.

Assuming the CDIC limits are followed in portfolio construction, a GIC is close to risk-free. In other words, it has no exposure to the credit factor. GIC terms longer than 5-years are not covered by CDIC, so an investor would typically limit themselves to 5-year or shorter GICs. This limits exposure to the term factor.

With this in mind we would expect two things:

  1. GICs will outperform bonds in some years
  2. Bonds will have higher long-term returns than GICs

Similar to owning stocks in lieu of bonds, owning bonds in lieu of GICs will inevitably result in years of underperformance. This is one of the risks that investors endure to access the higher expected returns of an asset class. If bonds were guaranteed to outperform GICs at all times then bond prices would increase, decreasing their yields, and we would not even be having this conversation.

Historical data

Looking at annual returns going back to 1985 through 2017 we observe a few things that illustrate my previous comments. 5-year GICs have outperformed bonds in 5 of the 33 calendar years examined, or 15.15% of the time. Interestingly, 5-year GICs have outperformed stocks in 9 of the 33 years, or 27.27% of the time. In a year where GICs beat stocks we should not abandon stocks. The same is true for GICs beating bonds. Bonds are riskier than GICs, but they also have higher expected returns. This relationship shows up in the historical data.

Asset Class Annualized Return 1/1/1985 – 12/31/2017
Average 5-Yr GIC CAD* 4.97%
World Government 1-5 Yr (CAD Hedged) CAD 6.13%
Canada Universe Bond CAD 7.97%
US Stocks CAD 11.10%

Any asset class with a positive expected return in excess of the risk-free rate carries risk. The higher the risk, the higher the expected return. While it may not always feel good at the time, holding an asset class through periods of underperformance is a necessity when seeking higher returns.

Through all of this we should not lose the primary objective of holding bonds: reducing volatility through diversification. While bonds are riskier than GICs, they are still much safer than stocks in terms of volatility, and they tend to shine when stocks are crashing. For example, when the global stock markets dropped 31.21% in CAD between March 2008 and February 2009, the Bloomberg Barclays Global Aggregate Bond Index (hedged to CAD) returned +2.82% for the year.