Everything you need to know about interest rates, GICs, and bond funds.

Hello everyone. Hope all is well.

Here is the next edition of 3 Questions for Bill Richardson.

Question 1: Can we talk interest rates on this edition of 3 Questions for Bill?

Sure thing.  Interest rate movements have been crazy for the past two to three years and it has changed the way that people are looking at all things related to interest rate movements.  This effect has been felt quite differently depending on your age of demographic status.

Let’s start with the Baby Boom Generation.  Although Baby Boomers have profited by being on the right side of many things, like real estate and the stock market, they have been on the wrong side of interest rates.  When Boomers were buying homes in the late 70s/early 80s, interest rates were crazy high.  It wasn’t unusual to have mortgage rates in the high teens and if you examined your amortization schedule, you would have seen that you were paying almost entirely interest and hardly any principal.  Fortunately, as rates declined, real estate prices rocketed up, so it isn’t unusual to hear stories of people buying houses in the $60,000 to $70,000 range and if they continued to live in the same house, it is probably worth $1 to $2 million if you are in the GTA.

When Boomers needed to borrow money rates were high.

Now that Boomers are retired or retiring and have money to invest, rates have been crazy low.  They had some relief lately but it’s not like they can buy a Government Canada strip bond that is maturing in 30 years yielding 18% like they could have in 1980.  Using the rule of 72 (divide 72 by the interest rate and it calculates how many years it takes money to double), money will double every 4 years so if you bought a 30 year strip bond, it would double 7.5 times.  Ten thousand dollars invested at 18% would be worth almost $2 million today.  But many Baby Boomers needed money so often didn’t have extra money to invest at that time.

Interest rates have been declining since the early 80s and hit rock bottom at near zero during COVID so when Baby Boomers have money to invest, rates were low. 

Since the mid-2022, interest rates have been spiking higher.  On June 1, 2022, the Bank of Canada rate was 1.5% and has risen to 5% in just over 18 months.  GIC rates have followed and are now at a much more acceptable rate of 5.5%.  So that is providing a bit of relief for risk averse investors.

Those who are or have recently entered the real estate market are finding this rate increase very difficult.  For the Millennial generation, they have large mortgages compared to what the Boomers had, and many had floating rate debt because the only thing they ever knew was living with low rates.  It is common to hear that already squeezed budgets are being further stretched with 5-figure mortgage payment increases and they are seeking support from their parents. 

 

Question 2: Should people with money to invest go all in to GICs?

Many people turned to higher equity allocations when rates were so low, and the risk averse types really didn’t enjoy the volatility.  Some that we worked with turned to private markets (private debt & private real estate) and received acceptable rates without the volatility.  For most, a combination of equities and private lending with a sprinkling of private real estate has produced good risk adjusted returns and much lower volatility. 

When making interest rate decisions, the important thing to look at is the spread between a variety of options.  Some people we have spoken to have said that they were happy with the private lending returns in the 5 – 6% range when rates were low but now that they can get GICs at 5%, they think they should switch to GICs at today’s higher rates.

The problem with that thinking is that most private lending solutions are floating rate instruments so as rates go up, so do returns.  Private debt that was paying 5 – 6% are now 7 – 8% so the spread is still 2 – 3% over GICs.  Three percent higher return than GICs or 60% better…I would call that significant.

 

Question 3: Are bond funds a better option today?

The proper answer is sort of.  Most bond funds have an average term of 7 – 10 years.  Canadian 10-year yields are much lower than short-term rates and sit at around 3.5%.  By the time you pay a portfolio manager 0.5% to 0.9% to manage the fund and an advisor a fee, this return will be whittled down significantly.  The best time to buy a bond fund is when rates are high and expected to fall.  Choosing 3.5% vs. GICs today might not be a good choice because there is a negative spread against GICs but if we have a sudden drop in interest rates, the bond fund returns might be better in the short-term.  I’d be more likely to buy the bond fund if bond yields were more in the 5% range. 

I think the private lending option is still preferable to either bond funds or GICs.

 

Hope this helps.

Until next time,

Bill