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“Laddering” GICs, Bonds and Fixed Income Securities for Better Interest Rates

Many of us are disappointed in the interest rates on our investments.  Fixed income securities, such as guaranteed investment certificates, term deposits and bonds, are much safer than investing in the stock market.  However, current interest rate “yields” are low.  While bonds can provide capital gains, they can also provide losses, and these capital losses may or may not be offset by the interest earned on the bond itself.  Bonds and bond funds can provide very good returns, often exceeding guaranteed term deposits.  However, you need to consider whether you are willing to take the risk of capital losses on a bond fund (that you can sell at any time) in lieu of having a guaranteed return on a term deposit that must be held until maturity.  This risk analysis is especially important if you expect interest rates to rise in the future, when bonds may decline in value.  Discuss this with your investment broker (and do not use history as a prediction for the future).

Financial institutions call fixed income securities by various names, such as guaranteed investment certificates, term deposits, certificates of deposit, credit union deposit receipts, etc.  In this article, I am going to use the term “guaranteed investment certificate”, or GIC.  Furthermore, if the security can be cashed or sold before its due date (such as government and corporate bonds), I am assuming you are going to hold the security until its maturity date.

How can we get better rates?  Before I explain the ladder approach to maximizing your interest rates, I want to make a couple of other points.  First, when you visit your financial institution to buy a guaranteed investment certificate (or you get the renewal form in the mail), always ask them if they can do better than the current listed rate.  You should usually get a slightly better rate just for the asking, often 0.25% to 0.5%.  Second, if someone recommends a security to you that a much higher interest rate than those available at your financial institution, get a second opinion.  You are very likely taking too much risk or being deliberately set up for a big loss.

What is laddering, and how does it benefit you?  Picture a construction ladder.  Each step represents one year.  Year one is at the bottom, followed by year two, then year three, etc.  Each step you take up the ladder is a year that passes in your life.  Each year, the interest rates may have increased, decreased or remained the same compared to the prior year.

I will discuss laddering based on five year guaranteed investment certificates.  Five year guaranteed investment certificates issued by a Canadian chartered bank are insured and protected under the Canada Deposit Insurance Corporation up to $100,000 total per person subject to certain rules.  A maximum of $100,000 (including interest) of GICs in your name would be protected.  However, other types of accounts, including use of joint accounts, can expand your protection.  Visit www.cdic.ca for more details. Protection is also available from life insurance companies (www.assuris.ca) and credit unions (visit your provincial web site – for PEI it is http://www.peicudic.com/coverage.php).  Ask your advisor or visit the web site to find out more.

When buying GICs, you have a challenge – you must decide how long to lock in your money.  Under normal circumstances, the five-year interest rates are higher than those for shorter terms.  However, if you lock your money away today for five years, and interest rates rise next year, you will not be able to take advantage of that increase for another four years.  Do you wish to take this risk?  If not, using a GIC ladder will help.

The process has two key features.  First, you will usually invest in five-year GICs because of their higher interest rates (except when first setting up your ladder).  Second, you will be investing in new GICs each and every year, which means that you will not have all of your money locked in at a low rate when interest rates are rising.  (You may rethink this approach if you expect rates to fall in the future.)  While you cannot “time” the market to always achieve the highest rates, having such a system will help ensure you are receiving a very good average over the long-term.  Because you will have a GIC maturing each year, like the steps on a ladder, this is called laddering.  I will give you an example of how to set one up.

Assume that you have $100,000 to invest in fixed income securities.  This excludes money you will need to meet expenditures within the next year, which should be in a chequing or savings account.  You should also have money you need for an emergency fund (typically three to six months of living expenses) in a high interest savings account or other cashable investment.  Of course, if you have a large expenditure planned in your future (such as a new car), you need to ensure that you have money available at the right time for that purpose.  Finally, if you have credit card debt and loans, you should likely be paying them off first because the interest savings will probably be better than the after-tax interest income you can make from GICs.  Given those planning issues, how do you set up your GIC ladder?

To start the ladder approach, assuming you have no other GICs invested at present, you would take one-fifth of this $100,000, being $20,000, and invest it in a GIC with a one year maturity.  (Given current low interest rates for a one-year GIC, you may wish to place this allocation in a high-interest savings account if the interest rate is higher.) You would take another $20,000 and invest it for two years; then another $20,000 for three years; $20,000 for four years; and, finally, $20,000 for five years.  If you already own some GICs, make your new investments with due dates so that the total maturing each year is about the same for all years.  In rare situations, when interest rates are expected with some certainty to rise rapidly in the next few years, you may wish to shorten your ladder – perhaps spread the maturity dates over three years.  However, remember that the purpose of this method is to reduce your risks of guessing incorrectly.

Let us look at where you now stand after the above investments are made.  You have your immediate needs set aside in a chequing or savings account.  You have an emergency fund set aside in a high interest savings account or cashable interest-bearing deposit of some type.  Money for known future expenditures within the next five years (children’s education, automobiles, trips, etc.) are invested separately in fixed income securities with appropriate maturity dates.  Your credit cards and high interest loans are paid down.  And, you have the money for your long term savings invested in equal five year GICs, with one coming due each year.

One year passes, and you are now on the second step of your ladder.  The first GIC comes due, with the principal of $20,000 returned to you with interest.  If you need the money, you now have the opportunity to set it aside in a chequing or savings account.  Assuming you do not need it, because it was set aside for a long-term savings plan, you would reinvest it.  However, although this was a one year GIC maturing, you will reinvest it for a five-year term.  If you re-invested it for one year, it would mature in year two.  You already have a GIC maturing in year two from the investments you made when you set up your ladder.  Therefore, you need to reinvest it for five years so that you will have $20,000 (one-fifth) of your portfolio coming due in year six, adding another step to your ladder.  Because you already have money coming due in years two through five from your initial setup, all future maturities will be invested and renewed for an additional five years, giving you maturities in years six, seven, eight, etc.

As I mentioned above, the highest interest rates are usually available on five-year GICs.  By reinvesting each year for a five-year term, you will have a five-year moving average of the highest interest rates available, and one-fifth of your money available every year should you need it.  Of course, periodically, the interest rate schedule on GICs may pay a lower rate on five-year terms.  This will occur when economists believe interest rates have peaked and are going to decrease.  At such times, you should re-visit this strategy and get some professional advice on long-term expectations for the financial markets.

Periodically, because of additional savings you have made, or because of withdrawals, you will need to rebalance your ladder to make the yearly amounts equal again.  Also remember that diversification is your goal, and you need not have perfection.  You do not need exactly 20% per year; a range of 15% to 25% is reasonable.  My example was of one GIC per year.  Of course, you can have more than one GIC maturing each year, perhaps at different times of the year giving you even more diversification.

You may have several types of investment accounts (RRSP, TFSA, non-registered, RESP, RDSP).  You need not build a ladder for each account.  Look at your investment holdings as a whole, and ensure that your maturities are diversified when looking at the total amount invested in total.  If all of your money in your TFSA comes due in year 1, that means you should have equal amounts maturing somewhere in your other holdings over years 2 through 5.

Interest rates may be low, but at least this method gives you an average of the best rates going.  It reduces the risk that you have locked all of your money away for five years at a rate lower than will be available next year.

As said at the start, the laddering can work for all types of fixed income securities.  Even though bonds are fixed income securities and are lower risk than stock market investments, before investing in bonds, bond mutual funds or balanced funds, read my article about the differences between bonds and GICs titled Bonds are not Guaranteed – Understand the Difference between Bonds and GICs.   It will explain the risk of losses on bonds if interest rates rise.  If you own balanced funds, look at the rate of return on the bond allocation within your fund – are you making more than the fees you are being charged?  Are you earning 2% on your bonds in a balanced fund if you are paying 2.3% in fees to do so?  Unless your bonds are making more than your fees plus a guaranteed GIC rate, perhaps you should just buy GICs? See my article, My Issues with Balanced Funds.   Also, if your advisor is recommending mutual funds and equities to stay ahead of inflation, read my article on that topic also, titled Investing to Beat Inflation – Do You Need to be in the Stock Market.  Finally, I also recommend, Questions to ask your Financial Advisor.   This will help you know whether your advisor is more interested in your “interest” than his or hers!

Good luck with your investing, and feel free to email me from my web site if you have questions or comments.  Remember, you worked hard for you money – protect and invest it wisely.

Blair Corkum, CPA, CA, R.F.P., CFP, CFDS, CLU, CHS holds his Chartered Professional Accountant, Chartered Accountant, Registered Financial Planner, Chartered Financial Divorce Specialist as well as several other financial planning related designations. Blair offers hourly based fee-only personal financial planning, holds no investment or insurance licenses, and receives no commissions or referral fees. This publication should not be construed as legal or investment advice. It is neither a definitive analysis of the law nor a substitute for professional advice which you should obtain before acting on information in this article. Information may change as a result of legislation or regulations issued after this article was written.©Blair Corkum