Short-term GICs and savings accounts
Approx. yield risk
1% – 2%
If you want safety without locking in for the long term and you’re willing to put up with minimal yields, go for variable or short-term investments with negligible credit risk. Two common options are to buy a one-year GIC, or just stick your money in a high-interest savings account. As it happens, both yield similar amounts these days, about 1% to 2% per year depending on the institution. Given those choices, you’re often better off salting money away in a savings account because you’re not locked in and can get at your money easily. You can also opt for a low-risk tradeable investment like a three-month Government of Canada Treasury Bill, which yields about 0.90% on an annualized basis.
For either a one-year GIC or a savings account, it pays to shop around. The big banks tend to pay the lowest interest rates (about 1% per year for both). The best rates (currently around 2%) are found at regional or niche institutions which are particularly keen for funding at this moment. For instance, at press time, Achieva Financial, a division of the Cambrian Credit Union, was offering a one-year GIC for 2.25% and a savings account for 2%. National “alternative” banks, such as Tangerine, President’s Choice Financial, Manulife Bank, and Canadian Western Bank, were offering rates in the 1.3% to 1.6% range. Just remember that if you invest outside the most creditworthy institutions, make sure to stay within deposit insurance limits, which is generally $100,000 per depositor per institution in most jurisdictions.
Bonds and longer-term GICs
Approx. yield risk
You can get higher yields with longer terms in the bond market, but you need to understand that market’s particular risks. First there’s the credit risk, or the risk that the issuer will default. And second there’s the interest rate risk, or the risk that rising rates will cause the value of your bonds to fall.
Longer-term bonds yield a bit more, but they are particularly vulnerable to interest rate risk, which can be measured by a metric called duration. If your bond portfolio has a duration of 5, it means that a one-time across-the-board 1% increase in the interest rates of those bonds can be expected to result in a 5% decline in their value.
There are three main categories of bonds, each with a different risk profile and a different range of potential yields. The government bond market in Canada has very little credit risk, but a pitiful yield and plenty of interest rate risk based on long average maturities (The iShares government bond exchange-traded fund (ETF) XGB yields 2.11%, for example, with an average term to maturity of 10.77 years, and a duration of 7.63). The investment-grade corporate bond market yields a bit more, with a bit more credit risk, and slightly less interest rate risk because of lower average maturities (the iShares corporate bond ETF called XCB yields 2.75%, with an average term to maturity of 8.49 years, and a duration of 5.94). High-yield bonds (also known as “junk” bonds) yield more and carry a load of credit risk, but aren’t especially interest-sensitive (XHY yields 5.60%, and has an average term to maturity of 4.73 years, with a duration of 4.14).
While we’re willing to bet none of those yields will blow you away, the experts say you still need a healthy dollop of fixed income to provide stability to your overall portfolio, which helps counteract the volatility from your stocks. Since many economists think interest rates are likely to creep up starting later in 2015, it is a good idea to be cautious when it comes to longer-term bonds.
In this environment, many portfolio managers believe that the best option for moderately risk-averse investors is to invest the core of their fixed-income holdings mainly in investment-grade corporate bonds of short to moderate duration. They feel the extra credit protection from top-rated government bonds isn’t generally worth the low yields, while high-yield bonds don’t typically pay enough to justify the heightened credit risk. Just as importantly, high-yield bond markets tend to be volatile and largely mirror ups and downs in the stock market, so they don’t provide the stabilizing influence you want from fixed income.
Longer-term GICs are a good alternative to investment-grade bonds of similar maturity, provided you stay within deposit insurance limits. These days, five-year GICs from many of the more aggressive national non-bank financial institutions pay annualized yields of roughly 2.5%, similar to corporate bonds of equivalent maturity in the lower and middle reaches of investment grade.
READ: Market outlook 2015 »
Dividend-paying stocks and REITs
Approx. yield risk
You can also get relatively attractive yields from the equity side of your portfolio by investing in dividend-paying stocks and Real Estate Investment Trusts (REITs). Most large blue-chip dividend-paying stocks in the financial, telecom and utility sectors yield between just under 3% and just over 4%, which is often better than you can get from bonds issued by the same companies. REITs that are relatively conservative provide yields in a bit wider range, from just under 3% to over 5%.
Most stocks and REITs can be expected to increase these payouts over time, whereas the interest on bonds is fixed until maturity. Moreover, stock prices tend to be reasonably resilient in the event of rising interest rates and rising inflation, whereas bonds typically suffer much more. Dividends paid by Canadian corporations (but not REIT payouts) are taxed at lower rates than other income and therefore have an advantage when held in non-registered accounts.
However, despite the many advantages of dividend-paying equities, you can still overdo it. With few good yield-paying alternatives, prices have been bid up and yields have come down, so most equities of this type are fairly expensive by historical standards. Also, keep in mind that underlying stock prices tends to swing widely according to market conditions. Moreover, there is risk that many stocks or REITs will cut their dividends during bad times. The classic investment advice to moderately risk-averse investors is to maintain a balance between equities and fixed income that is somewhere between 40% and 60% of each. You can find our Retirement 100 list of top-graded high-yield stocks online at moneysense.ca/incomestocks.
Approx. yield risk
There is one more major asset category to consider and that is preferred shares, which offer an income that falls between bonds and common shares when it comes to reliability. The two main kinds of preferred shares are perpetuals, which pay a fixed dividend, and rate-resets, which pay a dividend that is initially fixed but which is typically “reset” after five years to either a variable rate or a new fixed rate based on current interest rates. If a company is faced with increasing financial distress, it will first cut its common-share dividends to preserve cash, then it will cut preferred-share dividends as a more serious action. It would only default on paying bond interest if it was in truly dire straits.
Canadian preferred shares are a good option when you’re looking for highly reliable income in a non-registered account, since their dividends are taxed at a lower rate than bond interest. Prices of perpetuals (which never mature) are highly vulnerable to rising interest rates, so be cautious about loading up on them given the risks of that scenario playing out. Rate-resets, on the other hand, are less interest-sensitive, but their yields tend to be lower. As an indicator of typical yields, the iShares S&P/TSX Canadian Preferred Share Index ETF (ticker CPD) has a trailing yield of 4.55% and invests mostly in blue-chip financials, telecoms and utilities.