The back half of 2024 saw Bank of Canada interest rates steadily declining, and thanks to improving inflation and economic conditions, they’re expected to decline even further. Existing shorter-term bond investors have benefited from declining interest rates as they capitalized on rising bond prices, whereas short-term GIC rates have fallen. Additionally, new buyers of mid-term and long-term bonds can now take advantage of higher available yields, driven by a noticeable shift in the Canadian yield curve. This article will discuss the advantages and disadvantages of bonds versus GICs in the current market environment.  

Current market yields

Mid-term and long-term bonds have seen more pronounced yield increases following US election results, as investors wrestled with the idea of how higher tariffs, fiscal stimulus and widening deficits may impact future inflation. The Canadian yield curve has displayed similar movements given strong economic ties with the US, albeit some divergence on country specific factors such as fiscal policies and local market dynamics.

The chart shows how the Canadian government yield curve shifted since the beginning of 2024. It is evident that shorter term (up to 3 years) yields have declined, while mid-to-long-term bond yields have increased. Bond investors can now take advantage of locking in these higher yields, along with resale flexibility and after-tax advantages, which are discussed below.

Why bonds?

When it comes to fixed-income investing, two popular options often come to mind: bonds and GICs. While we believe GICs may be suitable for some, alone they are generally not the best solution for achieving long-term investment goals. We’ll examine some advantages and disadvantages of bonds, contrasted with GICs, to help you determine which makes the most sense for an investment portfolio. 

Certainty

As we’ve seen, the recent decrease in interest rates has led to an increase in price for many investment-grade bond issues. Barring any defaults by the issuer—which is an extremely unlikely prospect for investment-grade corporates and essentially non-existent for government issues—a bond will mature at par, meaning the investor gets their money back. It’s important to remember that changing bond prices don’t matter much for investors if they intend on holding the bond until it matures, as they’ll be expected to be made whole. This is highlighted in the visual below.

So while GICs may feel considerably safer than bonds in the sense that they don’t exhibit any price fluctuations, any market declines caused by a changing rate environment can be recouped for a bond investor at maturity. Investors should also be aware that bonds with longer terms, such as 5 or 10 year bonds, may experience greater market price fluctuations as interest rates have more opportunity to fluctuate, but they are also recouped at maturity. 

Flexibility

Bonds are generally liquid instruments that are easily bought and sold on the market. GICs on the other hand, tend to be locked in until maturity and, if the contract can be broken, often include significant penalties for doing so. This provides a bond holder with much more flexibility or liquidity should they wish to access their investment for either an unplanned expense, or to reallocate the proceeds to a better opportunity set.

The tradeoff is that a bond’s value fluctuates, as we highlighted above. It’s important to remember that bonds can also appreciate or depreciate in value when rates—or expectations around future rates—decrease or increase, respectively. In either case, if held until maturity, a high-quality bond should return its par value to the investor with a high degree of certainty.

Taxes

While taxes are not the only consideration in making an investment, they remain an important one. The returns for GICs consist entirely of their coupon payments and are categorized as interest income. When held in non-registered accounts, this is always taxed at the investor's marginal tax rate (MTR).

With a bond, the total return or yield consists of its coupon or interest payment as well as price appreciation. Any price appreciation is categorized as a capital gain which is taxed more favourably with 50 per cent being taxed at the investor’s MTR.

Up until 2024 when central banks began cutting interest rates, the rising interest rate environment has led many previously issued bonds to decline in value—that is, they are trading at a discount to their par value. This means that an investor purchasing one of these bonds today would also receive a capital gain benefit if they held the bond to its maturity. As such, more investors have sought to purchase these high-demand, low-coupon bonds, trading at discounts to par. 

To illustrate, let's consider the below example which compares a GIC with a bond of a similar term and yield. The bond’s yield-to-maturity is the approximate sum of its  1.10 per cent coupon payments and its capital gains of 2.08 per cent coming from the bond gradually appreciating in value as it approaches its maturity date. The table below quantifies the favourable taxation attributed to the bond’s capital gain in terms of its after-tax return compared to the GIC.

Higher yields

A basic tenet of investing is that an investor should expect to be compensated for the risk they take. That is, if an investment carries a higher risk of loss it should be expected to generate higher returns as well. In the fixed-income world, the difference between the risk-free rate and the riskier security is known as the spread. In Canada, for investment-grade corporate bonds, this spread has ranged from roughly 0.4 to 0.9 per cent, as shown below.

A primary risk that a bond carries versus a GIC is the chance that the issuing company defaults on their debt. In reality, this has occurred less than 0.1 per cent of the time over the past 40 years for global investment grade corporate bonds.¹ An investor looking for a higher yield can pick up the spread and would appear well compensated for the ‘extra’ risk. This is a worthwhile consideration when selecting where to place your money.

Final thoughts

While yields on GICs can be appropriate for many investors, there are many high-quality bonds in the marketplace that offer competitive yields with a high degree of principal security, as central banks have commenced their tightening cycle and many bonds have appreciated in value. Additionally, as mid-term and long-term bond yields have increased, bond investors can now take advantage of locking in these higher yields. 

After considering the other benefits of owning a bond compared to a GIC, the case for doing so is strengthened—so long as an investor is comfortable with the notion of potential price fluctuations leading up to maturity. Every investor has different goals and preferences to consider regarding their investment decisions, and in some cases, a GIC may be the most appropriate. A better understanding of these two securities will allow investors to better determine the most suitable and appropriate investment for their portfolio.