With all the talk of interest rate hikes there has been a lot of discussion regarding whether to invest in GICs or bonds.
This article from Fidelity Investments dives into the subject and shows what the main differences are between the two products and why (depending on each individuals time horizon and risk profile) it may be more beneficial to invest in bonds over the long term.
What is a bond?
A bond is an investment in which an investor loans money to an entity for a defined period of time, typically at a fixed interest rate. Issuers include federal, provincial, state and municipal governments or their agencies, corporations, foreign governments and even private institutions.
Bonds are considered to be less risky than stocks and can provide a source of steady, predictable income in the form of interest, or coupon payments.
The value of a bond may fluctuate based on changes in prevailing interest rates, credit quality and other factors. Bond funds pool money from many investors to buy individual bonds according to the fund’s investment objective.
When you purchase a bond, you are lending money to the issuer, generally in exchange for periodic interest payments and the return of principal at maturity.
Bonds can be an important part of a diversified investment portfolio, because they typically exhibit low or negative correlations to stocks and may provide a steady stream of income, in addition to the potential for capital appreciation.
How are bond prices inversely correlated with prevailing yields?
Assume a hypothetical Canadian company issued $100 million of bonds, with a par value of $100, paying a fixed coupon of 3% for three years.
How does the price of the bond change over time?
If prevailing yields are the same as the annual interest, or “coupon” rate, of the bond, the price will stay at $100. However, if prevailing yields increase, as they did in 2022, investing in a bond that offered only a 3% coupon payment each year becomes less attractive, causing bond prices to trade below par, or below $100. As we get closer and closer to maturity, the price of the bond will converge with its par value when the hypothetical Canadian company in question is required to pay the $100 million back to its investors, at $100 per bond. This effect is called “pull to par.” Today, bonds are attractive, because many are trading below par; therefore, a bond investor’s total return is made up of both the annual coupon payments and the capital appreciation from the pull-to-par effect.
Three reasons bonds are better than GICs
1. Liquidity Another benefit of buying bonds is the daily liquidity and flexibility it adds to your portfolio.
2. Upside potential • Canadian bond returns were higher than one-year GICs in 33 of the last 40 years, representing 83% of the time. • Bonds had negative returns in only five of the last 40 years: 1994, 1999, 2013, 2021 and 2022. • Bonds rebounded in the years following negative returns, earning more than double the return of GICs in 1995, 2000 and 2014. Over four decades, Canadian bonds outperformed one year GICs 83% of the time. The average excess annual return for Canadian bonds was 356 bps per year.
3. Tax efficiency in non-registered accounts
If you can buy a one-year GIC paying 5% or a one-year corporate bond paying 5%, shouldn’t you just buy the GIC, because its guaranteed? Not exactly: remember the hypothetical Canadian company mentioned above? Given the sharp rise in interest rates that occurred in 2022, most bonds today are trading below par. What that means is your total return will be made up of interest and capital gains, while a GIC’s return is made up solely of interest, and therefore is taxed at the highest rate (if held in a non-registered account).
To conclude
The year 2022 was challenging for bonds, because the Fed raised interest rates by 425 bps. We haven’t witnessed rate hikes of this magnitude in over 30 years. Hence the opportunity, because further rate hikes of this size are unlikely, based on the Fed’s summary of economic projections released in December. In fact, a recent study by Bank of America found that global fund managers are the most overweight in bonds they have been in 13 years; they are clearly taking advantage of the opportunity.
Contact us today to learn what various bond products are available that would best fit you!
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