What’s Wrong With GICs?
Many financial advisors and banking representatives will steer their clients away from buying Guaranteed Investment Certificates (GICs) and recommend other investments instead. Often, these investments include bonds, bond mutual funds, segregated funds or stock-linked GICs. While for some these investments may be suitable, there are many cases where GICs are more appropriate. Let’s take a look at the role of GICs and the reasons why some advisors avoid GICs.
GICs fund loans
Banks and other financial institutions sell GICs to help finance their lending activities. Traditionally, a bank will borrow money in the form of GICs or other deposits and lend that money out at a higher rate in the form of mortgages or personal loans. The financial institution earns the spread between what they collect on loans and what they pay out on deposits.
Clearly, financial institutions need to borrow money to finance lending operations. So why do their agents sometimes steer investors away from GICs?
Low spreads
Though there have been several increases over the past couple of years, interest rates in Canada are still low by historical standards. During the preceding decade, as interest rates on both deposits and mortgages slipped lower, the spread between what a bank could pay on a deposit and earn on a loan was compressed. Increased competition in the marketplace further exacerbated this effect.
Banks and other financial institutions are great innovators and have developed many other financial products that help them to better achieve their objectives. In other words, products that are more profitable. With a GIC, the institution gets to borrow money, lend money, and earn a profit from the spread. With some other products, the institution gets to charge management fees in addition to profits earned on the spread.
The bottom line is, banks and other institutions need to offer GICs to help finance lending and to meet investor demand. However, if they really wanted to attract GIC deposits, they would offer higher rates. GICs are simply not as profitable as other products.
Advisor compensation
Many rate-savvy investors buy GICs from financial advisors rather than banks. These financial advisors have the ability to act as brokers and sell GICs from many different institutions, often connecting their clients with some of the highest GIC rates in the country.
Despite this capability, many financial advisors choose not to sell GICs. These advisors give various reasons why they don’t but the main reason is, again, profitability.
In truth, GICs pay very little commission compared to other investments. Bonds and bond mutual funds pay more commission than GICs, and equity mutual funds and stocks pay more commission than bonds. The general rule is the lower the risk, the lower the compensation.
Rather than sell GICs, some advisors may push their clients towards other asset classes such as bonds or bond mutual funds. If this strategy works, the advisor will likely never sell GICs as they won’t want to cannibalize their bond fund holdings.
Final thoughts
There are a lot of reasons financial advisors and banking representatives might give clients as to why they should use investments other than GICs but the truth is, very few things are appropriate substitutes and often yield less. From a risk perspective, the only comparable investments to GICs are Government of Canada bonds and high-interest savings accounts, both of which generally have lower returns. For example, as of Thursday, October 11 5-year Government of Canada bonds were yielding 2.38 per cent while 5-year GICs were yielding 3.24 per cent.
Bond mutual funds that primarily buy low-risk government bonds have historically outperformed GICs because as interest rates fell, bond prices rose, resulting in higher returns. In a higher interest rate environment, the opposite will be true.
If you have questions about your bond holdings, speak with your financial advisor.