Category: Guaranteed Investment Certificates

Why the popularity of shorter-term interest-bearing securities among Canadians, in particular GIC investments?  In fact, we in Canada are not the only investors who seem satisfied investing our money knowing that the rate-of-return might just barely cover the rate of price inflation, with a significant risk of actually losing money if inflation should rise even modestly.  And it is not just people who are content with the arrangement between ourselves and the borrowers of our money – banks, insurance companies and credit unions alike – corporations have been hoarding cash since the Financial Crisis too.

This past summer, Statistics Canada reminded us that corporations in Canada continued to grow their cash hoard rather than invest the funds in their businesses.  Of course, like people, companies don’t actually hold cash, but rather invest the money in low risk short-term interest bearing securities, often in Government of Canada T-bills and bonds, as well as commercial paper offered by financial institutions.

At the end of the second quarter of 2008, corporations held $373.4 billion in cash balances (Statistics Canada November 17th, 2009 study: Indebtedness and liquidity of non-financial corporations).  By the first quarter of this (2014) year the number had grown to a whopping $629.7-billion. So why the stubborn tendency to tolerate a near-zero rate-of-return?

There are at least two factors at work in my estimation.  One has to do with the economics of interest rates in the current environment, another with human nature and demographics.

First of all, what is an interest rate?  It embodies three important expectations-related factors: Real returns, inflation and risk.  We all are reluctant to part with our cash unless we’re able to earn what economists call a ‘real’ return.  Ask yourself, what rate-of-return would make you happy if there was essentially no risk (default, volatility) to speak of and no price inflation.  Whatever you buy today, will in theory cost you the same price next year and every year after that.  Most agree that the very long-term real rate of interest is somewhere between 2% and 4%.  However, you can easily see from the graph that the real rate of return provided by Government of Canada (as low risk as you can find) long-term real return bonds over the past ten years has been driven down since the Financial Crisis, as all governmental central banks strove to fight disinflation by dampening the general level of interest rates.

Has the return we expect from lending our funds really adjusted downward, or is it that the availability of securities providing the returns we normally demand has changed?  My guess is most folks would agree that the adage ‘once burned, twice shy’ aptly summarizes our tendency to be  biased by recent experience.  It is human nature to be sensitive to bad or good things that have just happened and to oftentimes unreasonably expect them to continue.  Also, we are confronted by a lack of options.  Securities available to us are not promising the rates-of-return we want, given the amount of risk we are prepared to stomach.

In fact, a quick look at one of many high-dividend oriented ETF’s, the iShares Core S&P/TSX Composite High Dividend Index ETF suggests that a collection of dividend paying stocks yielded 4.31% (as of October 2, 2014) over the past (trailing) 12 months.  As a bonus, the tax treatment of dividends is more generous than it is for interest income.  Indeed the stock market has done perhaps too well over the last few years, but judging by the massive dollars invested in short-term securities those equity returns have not been earned by everyday people. The issue is people just don’t seem to want the volatility that comes with investing in stocks; even when the selection of stocks is less risky than the overall stock market.  A real return with some risk is less attractive than no return at all, and it has been like this for quite awhile now. The second ingredient to interest rate levels is inflation expectations.

Admittedly, we haven’t seen a whole bunch of price inflation have we?  Central bank policy around the world has been more interested in creating some inflation, fearing that disinflation would prove devastating to our economic welfare.  These efforts are in fact evidenced by the historically low level of administered interest rates we have.  If our collective expectations concerning future price inflation are significantly different from what we are experiencing then our behaviour will reflect it. Could it be that the extraordinarily high commitment to GIC’s and equivalents is that Canadians, and Americans are doing it too, are content to simply keep their money (even at the risk of a small loss) intact until rates of inflation and returns get back to levels they think they can believe in?

The third important determinant of interest rate levels is our toleration for risk, and it exists in many different forms.  Our appreciation for the risk of default was certainly modified during the Financial Crisis; and in short order we’ve been willing to tolerate none of it.  We’ve turned a blind eye to significant stock market appreciation and even bond returns preferring to ‘check’ rather than ‘raise’ and ‘all in’ has certainly been out of the question.   But this intolerance to take risk has become very sticky at the individual level and at the corporate level.  This might have more to do with demographics than anything else.

Younger people are quite surprised to learn that real interest rates got as high as 6% – 9% during the mid-1980’s, and during the 90’s and up to the turn of the millennium ranged around the 4% level. (Source: I was there!)  There is a large proportion Canadians who lived through those times.  According to Statistics Canada there is roughly an equal number of young people as there are older people.  Half of us in Canada might consider those times ancient history (or have no interest at all in history), and the other half feel as if it was just yesterday that mortgage rates were in the double digits.

These more seasoned citizens look at the rates of return offered by the bond market and similar investment vehicles and say to themselves: “Hey, if I buy a longer term bond, I’m earning next to nothing anyway, so I’ll just put money into shorter term GIC’s and term deposits that are effectively earning nothing and avoid the risk of having my money tied up.”  Having experienced periods of rising inflation and higher real rates, they (and yes, I’m a member of that distinguished group) are inclined to wait until more generous returns come back – if they ever do come back.  And don’t forget, these same folks might actually have to spend their savings sooner rather than later suggesting that any risk of a big loss in the stock or bond market is simply untenable.

Most people when they think of Canada bonds, immediately think of Canada Savings Bonds.  They are not the same at all.  Normal Government of Canada bonds, held in mutual funds and pension plans for example, rise and fall in value as interest rates change.  Although we’ve been through a very long stretch of falling interest rates, which made bond prices steadily go up in value, there have been and will be periods when interest rates rise and people lose money in bonds.  It is smart to learn how the time value of money works and how and why bonds can make or lose money.  There is a plethora of online videos that can help you understand bond valuation and the investment in your time to learn bond dynamics is well worth the minimal effort.

The yield curve is simply a plot of interest rates corresponding to varying maturities at a point in time.  Ordinarily, we expect to earn higher returns the longer our money is lent to someone else.  GIC rates are lower when the hold period is 3 months than they are when your money is tied up for 3 years.  The same should be true for bonds.  But consider where we’ve come from:  The graph shows the yield curves for US Treasury bonds as of October 2007 compared to the same today.  The 2007 yield curve reflects the uncertainty at that time about, well almost everything.  We didn’t know if we should accept lower rates for shorter investments or high rates for longer term bonds so the curve was somewhat flattish.  What would inflation be?  Which financial institution would be solvent?  Would the US government even be solvent?  Many questions but few answers in the midst of the financial turmoil.

The more current yield curve reflects today’s reality.  The only interest rates we can earn in the short-term are hovering close to zero, and since longer-term risk-free bonds are paying us barely one percent over inflation why assume the added risk.  If interest rates do rise from these low levels, then you will certainly lose money owning the longer-term bonds.

In a nutshell, people have doing what they should be doing – seeking shelter and waiting it out.   A side-effect of this behaviour is that our willingness to tolerate no return for lots of safety has stalled the return to financial market normality.  By stubbornly remaining in GIC’s, term deposits and money market funds we are inadvertently delaying what we desire – a decent return for taking some risk.  It’s only when money moves freely and to a large extent greedily that financial markets function properly.  This presents quite a conundrum for policy makers around the world, who’ve been praying that businesses invest in business instead of hoarding their cash, and people begin spending more and taking on more risk by investing their savings in more diverse ways.

There are many pundits who have suddenly jumped on the bandwagon predicting a stock market meltdown and impending bond market rout.  If they are right and this happens then we might finally get what we want after-the-fact; returns that compensate us fairly for inflation and risk.  In fact the stock market is suffering of late, and a shift (or rather, twist)  in the yield curve is already causing some havoc for bond managers.  The longer-term rates have declined rather than risen as expected, and mid-term bond yields have surprisingly risen – causing grief even for gurus like Bill Gross, who co-founded PIMCO and until recently managed one of the world’s largest bond portfolios.

If investors have been doing the right thing to feel secure, what should they be doing next?  Over my own lengthy career I’ve found that at some point it is important to combat inertia and begin moving in a different strategic direction.  As stock prices adjust downwards, take advantage of what happens.  The dividends paid on the increasingly lower stock prices become more attractive quickly, and remember they are taxed at preferential rates.  The world economy may continue to grow at only a snail’s pace, so why not test the waters so to speak and begin putting some funds into longer-term interest-earning bonds.  If inflation does creep up and interest rates increase some, then put even more funds to work at the higher yields.    Having done the safe thing during turbulent times, perhaps it’s time to do the smart thing.  Experience teaches us that the best time to be doing the smart thing is almost always when it is most difficult to do it.  The longer you earn nothing, the poorer you get.