For income-oriented Canadian investors the choice between a Bond ETF and a GIC or high interest savings account has become more important than ever. With interest rates at historic lows (and not looking up any time soon) picking the best option for the “safe” part of our portfolio can make a substantial difference to the amount of income your portfolio can generate each month.
In this post, we’re going to cover the pros and cons of the different investment vehicles that you can use to keep your money safe, while still have them generate some growth to keep up with, and hopefully exceed inflation.
The Bonds vs GIC vs High-Interest Savings Account Debate
Traditionally, when it comes to the “safe” portion of your portfolio, the default choice for many Canadians, has been to buy a bond ETF. It’s quick, easy, and free with Questrade.
The problem however, is that in the current environment, bonds generate very little yield for the risk that they possess, compared to other more secure options like GICs and high-interest savings accounts.
The large negative with bonds, is that their returns are not guaranteed. Also, when interest rates go up, we can expect our bonds to drop in value.
GICs and high-interest savings accounts don’t have this problem, and so the issue becomes: If we are taking on this interest rate risk by holding something like a bond ETF, then we at least want to be compensated for that extra level of risk (by receiving a higher yield).
If we are not going to be compensated for that risk, then why wouldn’t we instead hold something that is guaranteed like a GIC or a high-interest savings account?
Typically, GICs and high-interest savings accounts have CDIC insurance, which means you are covered if the bank was to default (among other things). Bonds are not included as part of this CDIC coverage.
Aside: Always make sure that your bank has this CDIC insurance before you use them. A good example (and the bank that I use) is EQ Bank (you can check out their features here) where you’ll see the CDIC logo right at the bottom, as well as a link at the bottom that says “CDIC Member” where you can click to learn more.
Why is this Fixed Income so Important?
The reason that this debate is very relevant now, is that the yield that you’re receiving on a bond ETF is not always higher than the guaranteed interest that you could receive on a GIC or high-interest savings account instead.
For example, a very popular low-cost, index ETF in Canada that represents the Canadian bond market is ZAG. If you do your own research, you’ll see many financial writers have this as one of their top bond ETFs for Canadians.
While I too agree that this is a great ETF for the bond portion of our portfolio, at the time of this writing, it’s only generating a yield of 2.16% (looking at its “weighted average yield to maturity”).
Compare this to the best high interest savings accounts in Canada, some of which bring in a guaranteed just under 2%*.
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In other words, you are taking on interest rate risk with a bond ETF, and are actually receiving a yield (2.16%) that is less than a guaranteed 2.30% from a savings account.
What About Capital Gains?
A quick refresher for those of you that aren’t bond experts: Bond ETFs (and bonds in general) gain value when interest rates go down. The idea is, that the bond you hold that offers a higher interest rate than you can currently get is now more valuable right?
So sure, the interest rates could drop further and increase the value of our bonds beyond what a savings account can generate, but how likely is it that interest rates will continue to drop further (considering that we are already at historic lows)?
And even if we refuse to speculate where interest rates are going, then it still comes down to the debate of:
Are you trying to maximize growth in the “safe” portion of your portfolio? Or are you trying to maximize stability?
As most will agree, the purpose of the stock portion of the portfolio is to generate the growth, while the fixed income portion is for the stability.
With that in mind, why take on interest rate risk with the hope that interest rates continue to fall (thus increasing the value of your bonds), when you can instead get a higher yield from a place like EQ Bank that is actually guaranteed and backed by the Canadian government through CDIC insurance?
I’m definitely not saying that we should sell all our bond ETFs and have all our fixed-income money in high-interest savings accounts or GICs (Especially since some of these options aren’t even available within an RRSP and TFSA).
I do however think that we shouldn’t just blindly invest in bond ETFs, while ignoring the other investment vehicles that do provide a guarantee, and in some cases, even provide a higher yield than the traditional bond ETF.
Are There Other Advantages to Bonds?
One potential advantage of bonds, is that when we do have a significant stock market decline, there is a chance that our bond ETFs will go up in value, helping offset some of those stock loses.
We can then rebalance, which will help us use some of the bond portion to purchase our stock ETFs at their temporarily depressed prices.
However, this relationship of bonds going up when stocks go down is also not guaranteed, as was the case in the 2008 financial crisis where both stocks and bonds dropped in value.
Diversifying Your Fixed Income:
After interviewing dozens of financial planners and experts on my show (you can stream/download them all here), one recurring strategy that I hear recommended by financial planners, is to diversify the sources of our fixed income.
For example, instead of having all our money in either stocks and bonds, we can instead diversify our fixed income sources. For instance, having a portion of our fixed income in bond ETFs, a portion in GICs, and a portion in a high-interest savings accounts.
This way, we are not fully subject to the volatility and lack of guaranteed returns from bonds, but still have some skin in the game to use bonds as a diversification tool to help us with the rebalancing when the stock market undergoes corrections in the future.
Real-Life Applications: Accumulation Phase vs Early Retirement
When it comes to the fixed income portion of your portfolio, the composition should vary depending on what stage you are at within your financial independence/early-retirement journey.
Let’s take a look at each one:
Fixed Income During the Accumulation Phase:
When you are still working and saving as much as possible, I suggest keeping your fixed income as low as possible, and maximizing your equity exposure, up to the point that you feel comfortable.
There are some great free questionnaires that can help you in determining how much equity you should take on, such as this one by Vanguard.
Here are my thoughts on the three investment vehicles that we discussed, specifically for this phase in your financial independence journey:
Keep them as low as you can handle, but not so low that you panic sell when we have the next major recession (i.e. If you’re 100% stocks, can you handle a 40%+ decline in your portfolio?).
Remember to buy them through a discount brokerage that lets you buy them without any commissions. I personally use Questrade because they let you buy ETFs without commissions, as opposed to paying $5 to $10 per trade through many of the banks.
The $5 to $10 per trade may sound trivial to some, but if you’re buying 4 ETFs every month using a portion of your latest paycheque, then that’s an extra $20 to $40 that you’re spending every month on something that you could be getting for free from Questrade:
I rarely see a use for these during the accumulation phase, unless you know that you have a big expense or cash outflow coming up, and you need that money safe and guaranteed while maximizing the interest rate that you receive.
Often you’ll find the interest rate you get on a GIC to be higher than what you get in a high-interest savings account, but the downside is that you can’t take out the money for the term that you agree to.
Personally, I prefer using a high-interest savings account instead of a GIC because I want my cash always available for day-to-day spending, and financial emergencies rarely come up when we expect them to, so we don’t want that money locked away and unavailable when we need it most.
High-Interest Savings Account:
This is what you’ll be using for your emergency fund. The most common timeframe that many experts suggest is 6 months of living expenses.
I like this being large enough so that if you lose your job, you never feel rushed to accept a job that you don’t really want because you need the money.
In addition to this amount being large enough to supplement your income if you were to lose your job, you also want it large enough to cover any large expenses that you foresee occurring in the next year. For example, a roof replacement, car replacement, etc.
Financial Independence/Retirement Phase:
While there is no one single best way to structure fixed income in this phase, it is here that you can really maximize the use of all three of these investment vehicles.
Once we hit our financial independence number, I found that the ‘bucket strategy’ gave me the most peace of mind, while the markets continued their never-ending turbulence.
While there is nothing wrong with a “total portfolio” approach in retirement (where you don’t segment your portfolio into buckets and instead just withdraw a fixed percentage or predetermined amount), I found it made me a lot less nervous knowing that I had a piece of my portfolio in safe and guaranteed investment so that we would be fine, even if we hit another 2008 Financial Crisis shortly after retiring.
There are many different variations of the bucket strategy, and it’s worthwhile working with a fee-for-service financial planner to have one that is custom-tailored to your specific situation.
But, one that I personally settled on before my wife and I quit our day jobs, is to have five years of expenses secured in guaranteed investments. I chose 5 years because historically, it has taken around that or less for the stock markets to recover after a major downturn (depending on how you calculate it).
To be a little bit more aggressive, I calculated a conservative amount of interest and dividends that we can expect to receive over those 5 years (even if we hit a major recession), and subtracted that from the 5 year cash cushion requirement.
In that 5 year cushion requirement, I also subtracted a very conservative amount that I expect to receive from other side income projects that I do for fun.
I found that knowing that I don’t have to touch my equities for 5 years gave me the piece-of-mind I needed to not be constantly thinking about the markets, once we quit our jobs and didn’t have those reliable paycheques from an employer coming in every two weeks.
In terms of structuring this, one strategy that I liked is having 1-2 years in a high-interest savings account (I currently use EQ Bank due to the high interest rate on their EQ Bank savings plus account), and then having years 3-5 in either a GIC, a high-interest savings account, or a combination of the two.
Another more conservative strategy that I’ve seen is to:
- Have years 1-2 of expenses in a high-interest savings account.
- Years 3-5 in a GIC ladder. You won’t need that money for several years so it can make sense to lock it in at a higher rate than what a savings account can offer.
- Have enough in bond ETFs to cover expenses from years 6-10.
- Put the remaining into low-cost index ETFs that track the equity markets (i.e. S&P 500, S&P/TSX, etc.)
I once thought that there was one correct way to structure it all. However, after interviewing many financial planners on my show, I quickly learned that while it’s great to have an understanding of how others do it, you do need to be willing to make the necessary tweaks so that you feel comfortable in your own financial independence/retirement journey. After all, not everybody has the same risk tolerance, lifestyle ambitions, income opportunities and expenses.
Is there a type of structure that you think would work better for you? Are there any pros or cons that you think I missed? Let us know in the comments.
Looking for more to read? Check out Kyle’s article on The Ultimate Guide to Safe Withdrawal Rates.
* Interest is calculated daily on the total closing balance and paid monthly. Rates are per annum and subject to change without notice.
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