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The GIC free buffet - conditions apply

GIC rates have risen from ~1% at the start of the year to ~4% today. While there are many good reasons to own GICs, there are other important considerations to keep in mind before you assume this is a free lunch.

Anna Premyslova joined CWB McLean & Partners’ team in August 2019. As an Associate Portfolio Manager, she has a meticulous approach to portfolio management and is ingenious in providing exceptional client service. Anna holds the Chartered Financial Analyst designation.

Why bother owning stocks or bonds right now when you can get 4% on a 1-year GIC?

If you’ve found yourself following this line of thinking recently, you should know that there are many good reasons to own GICs – but the dramatically improved return rate from ~1.0% at the start of the year to ~4.0% today isn’t one of them. 

In a year where stocks (and even bonds) are already 10-20% off from last year’s highs, it’s easy to see why a guaranteed return of 4% sounds irresistible to many. But as experienced investors know, there’s no free lunch in the markets. And the jump in GIC rates hasn’t come for free either.


The fine print
In reading the fine print, investors will find that the prime rate, which acts as the proverbial “reference rate” for all types of both borrowing and lending rates Canada-wide, has also risen dramatically from 2.45% to 4.70% so far this year. This means that the same investors who have been gifted an extra 3.0% on their GIC rates have also had 2.25% added to the cost of their home equity lines of credit, car loans, mortgages, and commercial borrowing. Still good, but not quite as lucrative as you would think.

But what of those with paid-off houses and no other debt to worry about? Surely this year’s juicy GIC rates are a promising investment for them? Enter: the invisible cost of living, inflation. 

Even when inflation is low and predictable (as it was from mid-2014 until the 2020 pandemic began), GICs are just not built to offer much in terms of inflation-adjusted return. In fact, by the time inflation was done chewing up their returns, 1-year GIC investors were left oscillating around a “real return” (the return after inflation has been taken into account) of roughly 0% over that time.

So far, this only goes to prove what we all already know: that until the COVID-19 pandemic came along, GICs didn’t exactly present an excellent return strategy in inflation-adjusted terms. 

The real rude awakening for GIC investors is what came next. After a sharp but brief drop, inflation has come roaring back to levels last seen 40-odd years ago. And while GIC rates have certainly risen, buoyed by the Bank of Canada’s “emergency brake” strategy of cranking up interest rates, they haven’t even come close to offsetting its effects.

Figure 1: 1-year GIC rates vs 1-year inflation rates – 2014 to present 



Source: CWB Wealth Management, Statistics Canada

Investors who locked in one-year rates of 1% in January are now finding that despite their ending balance reading higher, their dollars are actually worth ~6-7% less than before due to inflation. And while inflation is expected to ease in the medium-term thanks to government intervention, it will need to be reduced by half over the next 12 months just to make a 4% nominal return once again equal 0% in real terms.

This doesn’t mean that GICs don’t have a valid and important role to play in many investors’ portfolios. Buying peace-of-mind against market volatility, meeting upcoming cash outlays while still earning some interim interest, or simply keeping money safe and inaccessible to spending are all great reasons to include them in your overall wealth picture. Just as long as you don’t expect a free buffet. 

What else is on the menu?
If the big draw of GICs is that they pay no matter which way the markets are going, then let’s not forget that there’s another contender in the recurring income game: dividends. 

Dividends can be thought of as the salary that your portfolio makes just for showing up to work each day, regardless of how that day turns out. This means they can be a reliable source of income even during times of market unrest. 

Take the Leon Frazer (LF) Canadian Dividend Growth strategy, a concentrated portfolio of ~30 high-quality Canadian companies, that aims to create a steady-and-growing stream of dividend income.  

Today, the LF dividend strategy is yielding 4.07% and has averaged an annual dividend growth rate of 6% since its inception in 2006. This can be a very meaningful return. For example, if two investors – both in the highest marginal tax bracket – were to deploy one million dollars today, one into the LF dividend strategy and one into a 5-year GIC at the current rate of 4.5%, their income over the next five years could look as shown in figure 2.  

Figure 2: Pre- and post-tax income on dividends vs GICs over 5 years

 

 

Income Source

Pre-tax total (5 years) 

Post-tax total (5 years) 

Dividends 

$229,430 

$150,712 

GIC income

$225,000 

$117,000 

Difference ($)

$4,430 

$33,712 

Difference (%)

2.0% 

28.8% 

Sources: Bloomberg, CWB Wealth Management

 

Not only do Canadians in the highest marginal tax bracket pay 48% tax on GIC income versus ~34% on eligible Canadian dividends, but dividends are also inclined to grow over time while GIC rates are locked in over the length of their term. Even ignoring any capital appreciation on the dividend-paying companies themselves, these factors lead to a +$33K difference in total after-tax income over a five-year period.  

Of course, dividend investors do need to contend with the inevitable ups and downs of the markets, even when their stream of income remains unaffected. So, the moratorium on free lunch remains. But, in a year where bonds and stocks are suffering a rare outflow of investments, it can pay to be greedy where others are fearful. After all, a free lunch may not come around much in the markets, but ordering the right lunch can taste very fine. 


Sources: CWB Wealth Management, Bloomberg, Statistics Canada