GICs vs. bonds: What’s the difference?

If you’ve ever had a mortgage or carried a balance on your credit card, you know how those interest payments can add up over time. Now, imagine what it would be like if you were the one collecting that interest. Well, when you purchase a Guaranteed Investment Certificate (GIC) or a bond, you effectively become a lender.

GICs and bonds are two relatively low-risk ways to make money by lending some of your own money to another entity, such as a bank, government, or corporation. But for all that GICs and bonds have in common, there are a few key differences to consider before investing in either.

What is a GIC in simple terms?

When you purchase a GIC, you’re agreeing to loan money to a financial institution for a set period of time — usually between 30 days and five years — at either a fixed or variable interest rate. Although GIC terms can vary considerably, generally speaking, the longer the term, the greater the interest rate. In addition to the interest you earn over the term, GICs also return your principal when the term wraps up.

Why choose a GIC? Who is it for?

GICs are often popular among investors because they are widely available and provide low risk, guaranteed returns. Also, as most GICs are insured for up to $100,000 by the Canada Deposit Insurance Corporation (CDIC), if your lender encounters challenges, your investment remains low risk. GICs could therefore be a good option for anyone who wants to grow their savings without risking their principal, either in the pursuit of short-term goals, like a wedding, vacation or renovation, or long-term savings.

Things to keep in mind when investing in a GIC

Like any investment, there are a few things to consider when buying a GIC:

• Most GICs require you to lock in your money for an agreed-upon term. These GICs are called non-redeemable, meaning your dollars can’t be withdrawn prematurely without penalty. If you want more flexibility, there are also redeemable GICs, but they tend to be issued at lower interest rates.
• The returns you get with a GIC are typically lower than those you might get with other asset classes. To get the most out of your GIC, it can help to shop around until you find a rate and term you’re happy with. One strategy is to ladder your GICs by buying products with different length terms. For instance, you might buy five GICs — one that matures in a year, another in two years, another in three and so on. With this strategy, a portion of your investment will mature every year — either to be used or, if you don’t need it, put back into another GIC (albeit with a different rate).

What is a bond in simple terms?

A bond is another type of fixed-income investment that a government or corporation issues to raise capital for any number of reasons, including funding a new project. When you buy a bond, you’re essentially agreeing to take on a portion of the issuer’s debt. In exchange for this loan, the issuer agrees to pay regular interest (known as coupon payments) to its investors, before returning their principal once the bond has matured. Bonds, like GICs, are often referred to as fixed-income investments because they provide a steady stream of income until their term is up.

In addition to buying individual bonds, you also have the option of investing in a bond mutual fund or Exchange-Traded Fund (ETF). These funds allow you to pool your money together with other investors while gaining exposure to dozens, or in some cases, hundreds of bonds all at once. Because of their diversification, investing in an ETF or mutual fund can be less risky than purchasing a single bond. It’s important to note, however, that such funds may be subject to management fees.

Why choose bonds? Who are they for?

Bonds are an attractive option for investors who want to protect their savings while generating new income. These tradeable securities (meaning they can be sold before they mature) are typically considered less risky than stocks because of their fixed payout and known value at maturity. Historically, bonds have risen in value when stocks fall — although that is not always the case — and thus they remain an effective way to diversify a portfolio.

Things to keep in mind before investing in bonds

The primary risk associated with buying a bond is the chance the issuer (borrower) could default on the loan before it matures, but there are other potential risks to keep in mind as well:

• Bonds that carry a higher risk of default generally offer higher interest payments to reward investors who are willing to assume that risk.
• The risk of default is tied to the financial stability of the issuer. Government bonds, for example, are considered to be more stable, so they carry less risk and offer lower interest as a result. Corporate bonds, on the other hand, are often riskier, so they tend to offer higher interest rates.
• When interest rates rise, the existing bond value falls, making it harder to sell a bond on a secondary market.
• Prepayment risk occurs when rates move low enough to entice the issuer to pay back some or all of the capital early. This, in turn, forces bond holders to reinvest their money at lower, less desirable rates. The ability to prepay capital is determined when the bond is issued, and those terms would be included in the bond contract (which is typically referred to as a bond covenant).

GIC vs. bond: Key similarities

GICs and bonds share key similarities:

• They both represent loans from investors to different entities in exchange for a return of principal plus interest.
• They’re both popular methods of diversifying a portfolio, while generating a steady stream of income.

GIC vs. bond: Key differences

While GICs guarantee the return of your principal and a set rate of interest, bonds do not. As a result, bonds tend to offer higher interest rates than GICs. For those who value security, GICs are typically the safer of the two investments because, when purchased from a CDIC registered financial institution, your investment is insured for up to $100,000.

There are no such guarantees with bonds and, because bonds can be bought and sold before they mature, their value can fluctuate. When interest rates rise, the price of existing bonds fall. In that case, you could incur a loss on the principal component of the bond. For example if you bought the bond at a premium (paying, say, $110 for a bond that has a par value of $100) with a rise in interest rates, that bond would then trade at a discount (i.e., $95). If you were to sell at that point, you would lose $15. Of course, some of this loss would be offset from the interest/coupon payments that you’ve been collecting.

What historical performance can tell us about GICs and bonds

In the 1980s and early 1990s, a difficult economic environment marked by high inflation led the central bank to raise interest rates. This, in turn, led to strong GIC returns. As the economy stabilized once more, interest rates fell.

Bonds have experienced similar periods of strength and weakness. For both bonds and GICs, performance is highly correlated with the overall economic environment. Generally, during periods of economic uncertainty, fixed-income investments tend to perform better than equities. GICs rates also rise and fall based on whether the Bank of Canada’s key interest rate goes up or down.

What are some trends to watch?

With GICs
Rising interest rates can make GICs more appealing, but the ROI (return on investment) will depend on a number of factors, including the term length, the interest rate being offered and whether or not the investment is redeemable.

With bonds
Similarly, the return you can expect from purchasing a bond will depend on the type of bond, its rating, the term length and how long you plan to hold it before selling. Here are some resources to help you understand the current fixed-income environment.