Why GIC-loving Canadians should give bond funds a chance

Canadian fixed-income investors should look past the afterglow of 2022, according to Vanguard Canada

Why GIC-loving Canadians should give bond funds a chance

Against a backdrop of skyrocketing interest rates and tumbling bond values, many Canadian fixed income investors have been flocking to GICs as yields on the products start to look more alive than they have in years. But Vanguard Canada is encouraging that crowd to not be swayed by their sticker-price delight.

“We think there's definitely a role for GICs for clients,” says Sal D’Angelo, head of Product at Vanguard Canada. “But it really doesn't come down to which product is better – it comes down to the client’s needs.”

According to D’Angelo, GICs are a suitable alternative for clients who have high risk aversion, a need to protect capital, or shorter-term investment requirements. The products may also be a good fit for situations where immediate liquidity isn’t an issue.

GICs may be a better-looking option than bond funds in the immediate afterglow of 2022. Last year, bonds across the spectrum saw massive capital losses as central banks engaged in extremely steep rate-hiking campaigns. As investors saw the values of their bond portfolios crater, GICs suddenly looked like more effective fixed-income ballast against the short-term turbulence of the markets.

“Clients have to remember that most of the total long-term return of an individual bond, probably more than 90%, comes from the coupon itself, not its capital appreciation or depreciation,” D’Angelo says. “With yields now at a much higher level, bond coupons are very favourable.”

When it comes to the majority of investors who are still in their wealth accumulation phase, Vanguard’s research points to bond ETFs or mutual funds as the better option on balance. For one thing, bond funds show better portfolio returns over the long term than GICs: it found that a starting investment of $1 million in a broad bond index in November 1980 would have ballooned into $21 million by September 2022, versus just $5 million for the same investment in one-year GICs over the same period.

“If we look at rolling one-year returns back to 1976, investors have encountered a loss in both stocks and bonds in just 0.6% of instances, showing how unique 2022 really was,” D’Angelo says.

Bonds also have a solid history of diversification over the long term. Last year’s perfect storm of inflation and high interest rates caused both stock and bond markets to drop like stones. But the record shows that for both U.S. and Canadian markets, the correlation between stocks and bonds has tended more to be zero or negative; in contrast, GICs don’t offer significant diversification benefit as their prices don’t change.

“We think now going forward, with inflation moderating and assuming unexpected inflation does not rise significantly, bonds will re-assert their traditional role as a buffer against equities,” D’Angelo says. “We also think the outlook for fixed income is very favourable as yields have reset now to higher levels.”

As the Bank of Canada continues to hike rates, Vanguard expects inflation to continue to decline. It also foresees a mild recession in Canada in 2023; the beginning of a recession, the firm says, usually comes with a flight to quality, which drives bond prices up and yields down particularly on the longer end of the maturity spectrum. With the prospect of both rising yields and falling inflation, bonds are well-positioned to provide strong real returns.

Against the current economic backdrop, any outlook will be riddled with asterisks and question marks. For some, that means it’s active management’s time to shine, and passive strategies will have a tough run of it. But D’Angelo takes a different view.

“Whether a strategy is active or passive, low costs are critical for investment success. And the reason most passive ETFs tend to outperform active funds is primarily due to costs,” he says. “Some of our oldest bond index ETF strategies have shown first- or second-quartile top performance because of our low-fee advantage and diversification.”

While many Canadian bond investors saving for retirement may have been rattled by the events of last year, D’Angelo says as long as their investment horizon is longer than the fund or ETF duration, rising rates will actually benefit them as the money they get from their maturing bond holdings can be reinvested into higher-yielding bonds.

Aside from moving into GICs, a large swath of Canadian retail investors are also moving into higher-income covered call strategies, which have seen a lot of growth in the past year. On that front, D’Angelo believes some caution is needed.

“There can be a lot of concentration in specific sectors or specific securities. And clients could be taking on unnecessary risk by having all their exposure to one sector of the Canadian economy when they have to whole world to invest in,” he says. “We don’t believe that’s the best way to build a diversified long-term portfolio.”