Interest rates in the United States have been raised twice in the past 4 months marking the first time in 10 years that there have been 2 increases within a one year period. This has many Canadian investors focused on when (not if) the Bank of Canada will start to do the same. Based on current economic data we believe the next move will be up, but that this is unlikely to happen until 2018.
Guaranteed Investment Certificates (GIC’s) are one of the only government guaranteed ways for investors to obtain a return on their savings greater than a high interest savings account. Standard GIC rates are generally static from the date of purchase to the date of maturity.[i]
Given the opinion that interest rates will go higher in Canada, one would be tempted to stick to shorter term GIC maturities. However, doing so comes at the cost of accepting a lower yield. The illustrations below are meant to show why we feel a 5yr laddered maturity approach to GIC investing is best for most investors.
Best available GIC Rates at NBF as of March 16th, 2017[ii]
2yr 1.60% 1-2yr Ladder Average Yield 1.525%
3yr 1.80% 1-3yr Ladder Average Yield 1.61%[iii]
4yr 1.91% 1-4yr Ladder Average Yield 1.69%
5yr 2.06% 1-5yr Ladder Average Yield 1.764%
If we assume that rates will move up at the same pace as any change initiated by the Bank of Canada then a quarter point increase early in 2018 would provide a yield of 1.7% on a 1yr GIC[iv]. Someone buying a 2 year GIC today may feel regret that they are stuck at 1.6% for the second year when they could have been getting 1.7%. However, they are actually coming out ahead. Earning 1.6% for 2 years is better than earning 1.45% in one and then earning 1.7% in the next (this annualizes at 1.575%)[v].
This measure of return can also be applied to decisions around using a 3, 4 and 5 year ladder.
At current rates an investor using a 3 year ladder would experience an average return of 1.61% in the first year of holding, while an investor using a 5 year ladder would receive 1.764%. The investor using the 3 year ladder will have a greater portion of their investment maturing each year and will capture increasing rates faster. However, the 5 year ladder investor will be reinvesting at higher relative interest rates each year and obtaining higher returns on their total savings.
The only real exceptions to this would be in the event of extreme interest rate moves (greater than 2% per year[vi]) or an inversion of the yield curve (suggesting 5 year rates could be lower than shorter maturities).
Bottom Line – When investing in GIC’s within a portfolio the longer the ladder the better
[i] It should be noted that GIC’s are generally illiquid from purchase to maturity. The guarantee (CDIC) is limited to the first $100,000 invested with any single GIC issuer.
[ii] Rates are subject to change daily
[iii] All figures assume interest earned is paid out annually.
[iv] This is done for illustrative purposes only. Longer term GIC rates are influenced by the bond yield curve as well as the prime lending rate and movements are unlikely to perfectly match the actions of the Bank of Canada.
[v] This assumes that interest is paid out and not compounded.
[vi] If we accept that each maturity will move with the prime rate then a 0.25% increase would influence the 3 year ladder by 0.083% (33%) and the 5 year ladder by 0.05% (20%). To overcome a return gap of 0.16% in the first year rates would have to have increased by over 2% within the 1 year period for the 3 year ladder to outperform the 5 year ladder in year 2. This does not account for any positive interest rate spread achieved by buying a 5 year maturity versus a 3 year maturity. At current rates overcoming this added spread on 20% of the ladder would mean the actual increase required is 2.5%.
** I have prepared this commentary to give you my thoughts on various investment alternatives and considerations which may be relevant to your portfolio. This commentary reflects my opinions alone, and may not reflect the views of National Bank Financial Group. In expressing these opinions, I bring my best judgment and professional experience from the perspective of someone who surveys a broad range of investments. Therefore, this report should be viewed as a reflection of my informed opinions rather than analyses produced by the Research Department of National Bank Financial **