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Why I'm Not Putting Any Capital Into 5%+ Yielding GICs
The hidden risks of accepting a known return
It seems like the introduction of a lot of my posts lately talk about how bad it’s been for Canadian dividend investors. Instead of talking about it again, I’ll let the following chart do the explaining:
The S&P 500 — represented by the VFV ETF above, has absolutely crushed a portfolio of Canadian dividend payers over the last year. The difference is even more stark when you compare it to the technology-heavy NASDAQ index. But we won’t do that. Us dividend guys have already been through enough.
It’s difficult enough to endure the struggle of a year where dividend payers have mostly grinded lower, but even worse when giant U.S.-based tech stocks are doing so well. Meta, the parent company of Facebook and Instagram, is up an eye-popping 246% in the last year, as anyone who managed to buy the stock a year ago will inevitably point out.
Even Canada’s tech sector is doing really well. Shopify, our top tech name, has skyrocketed more than 90% over the last year. Constellation Software, another investor favourite, is up more than 50% in the same time frame. Non-tech growthier stocks have held up pretty well, too.
In short, dividend payers have underperformed. And it hasn’t just been a year’s worth of poor returns, either. Many of Canada’s top dividend stocks fell in 2022 as well. Many are well below 2021 highs.
The same thing happens every time a certain asset class underperforms for a while. Investors leave and look for higher returns elsewhere, usually buying whatever has been working lately. For retirees and other folks who are looking for income, rising interest rates mean GICs are suddenly a popular choice.
I’ll often talk about a dividend stock on Twitter and folks will respond with some version of “why would I buy that when I can get a better yield in a GIC?”
They have a point. After yielding not much more than zero for years, GICs are suddenly paying pretty attractive rates:
On the surface, I agree that it makes sense to lock in a five-year GIC at 5%+, especially as the share price of many Canadian dividend payers are falling. It has certainly outperformed over the last few months, which have been particularly nasty to dividend payers as rates have spiked. Although the last week was a welcome relief.
But while the whole just buy a GIC and chill analysis might look pretty good today, your author is hardly convinced it’s a good long-term strategy. In fact, I think it’s pretty much the opposite of that.
Most people who are locking in their capital at a 5% guaranteed return today will be the first to get FOMO once dividend stocks start recovering. Because that’s what happens in the market. As soon as stocks have gone down, nobody wants them. That’s the time to buy. But instead of doing that, the average investor chases what’s hot. Or, in this case, the thing that doesn’t go down.
But we’ve gotten a little ahead of ourselves. Let’s look at some of the reasons why I’m not about to put a nickel of my cash into a long-term GIC.
The biggest downfall to a GIC is, ironically, exactly why they’re so popular right now.
GICs are great assets to hide in when the market is falling. Not only is your principal protected, but you’re also earning interest at the same time. With most GICs paying 5%+ and the market looking pretty uncertain, that’s a pretty sweet combination.
But principal guarantee comes with a pretty significant downside. When the market goes up again — and it will — GIC holders don’t get to participate.
When confronted with this information, GIC lovers generally have one of the following defenses:
The market isn’t about to go up again for a long time for (insert poorly researched reason)
My 5% interest is more than enough to make up for that downfall. In other words, they’re happy with 5%. Note this will change pretty much immediately once stocks start going up again. It always does.
They just don’t want to stomach any additional downside. This is the reason I respect the most, actually. Feelings are powerful things in investing.
All of these defenses ultimately don’t make much sense. The market tends to go up over the long-term. Locking in a 5% return looks pretty silly if the market tends to return 8-10% over time. Long-term, it’s simply a losing game.
Dividends are better than interest
The comparable dividend is much better than interest, especially in taxable accounts.
Firstly, dividends are taxed a lot better. In Alberta, you’d pay $3,000 in taxes on $70,000 in dividend income, assuming you have no other income. $70,000 in interest would cost you more than $14,000 in taxes. Your tax rate is less than 5% from dividends and more than 20% from interest.
I can already hear the naysayers. Nobody has just one source of income, and dividends are uniquely taxed well for folks who only collect dividends for income. Okay, fine. We’ll do another example, which assumes $100,000 in employment income and then $40,000 in dividends or interest.
Since I’m from Alberta, we’ll present the findings for an Alberta tax payer. The total tax bill for someone with $100,000 in employment income and $40,000 in dividends is a hair over $30,000, for an average tax rate of 21.6%.
The same tax bill for someone with $100,000 in employment income and $40,000 in interest is $37,246, for an average tax rate of 26.6%.
For those of you from Ontario, the average tax rate for the dividend-centered approach is 22.8%, while it jumps to 27.9% for the interest-centered approach.
I would much rather get a 5% dividend than 5% in interest. It isn’t even close, either.
Dividends also have a habit of going up over time, too. The Canadian market is littered with solid dividend stocks paying at least 5% right now, stocks with a demonstrated history of raising their payouts regularly.
Take Bank of Nova Scotia (TSX:BNS) shares. I know nobody likes Scotiabank these days, but shares are yielding more than 7%, a dividend that has been raised consistently (outside of the 2008-09 crisis, anyway) for decades now, and that has a payout ratio of about 55% of expected 2023’s profits, a year which we’d all agree hasn’t been great for the banks.
Want another one? Okay. Rogers Sugar is a delightfully boring company that manufactures and distributes sugar, maple syrup, and other sweeteners. Shares trade for just 11x trailing free cash flow, and the yield is currently a hair under 7%. Rogers isn’t much of a dividend grower, but it has paid its current dividend for nearly 15 years. It’s a boring business that should do relatively well over time.
There are literally dozens of these examples, stocks that I’m confident that will at least continue to pay current dividends, with most growing those payouts over the long-term.
GICs aren’t even a great fixed income option
Not only am I no fan of GICs as a investment choice, I don’t even think they’re the best place to park your cash.
One of the big problems with GICs is you’re committed to putting your capital in a certain bank for the life of the GIC. Yes, you can always break the contract and get your money back, but that almost always comes with a penalty.
Some GICs don’t even offer you the option to pay a penalty and get your capital back. Unless you literally die, that cash is locked in. You ain’t getting it back.
You can always put your cash into redeemable GICs, which do allow you to cash out early with no penalty, but those offer significantly less interest.
The solution is a high-yield savings account (HISA). There are several options for this.
For instance, your author likes to keep enough cash on hand to cover around a year’s worth of spending. This capital is currently sitting in HISA accounts:
A high interest savings account from Tangerine (currently paying 6% interest)
A high interest savings account from Simplii (currently paying 5.75% interest)
The CASH ETF, which trades on the TSX (currently paying 5.4% interest, but that will be going down)
I’m getting rates comparable to a one-year GIC, but without all the downfalls of locking my money up for a year. It’s totally liquid. I can access the capital whenever I want, as well as getting some income from the interest.
Yes, GICs typically have higher interest, and you can be rewarded for locking up your cash in a market where interest rates drop. I’m well aware of that, but for me, liquidity trumps all that. I’d much rather make a little less on my cash in return for optionality.
Plus, my wife likes finding the best HISA deals on the market. And who am I to take away her greatest joy in life?
(Minus making me a sandwich, that is)
The bottom line
Ultimately, it comes down to this. The sudden interest in GICs has less to do with interest rates and more to do with the overriding fear many investors feel.
I talked about this a few weeks ago when I wrote about doomer porn. Fear is a powerful motivator. It becomes doubly powerful when the market is seemingly crashing around you. GICs become an option not because they’re attractive, but because everything else looks so unattractive.
I’m much more optimistic. I’m the first to admit we could see more weakness, that I have no idea where the market will be a year from now. But I’m 100% certain it’ll be higher five or ten years from now. That optimism allows me to view today as a temporary setback and put capital to work in what I view as undervalued dividend stocks.
A GIC might seem like the right choice today, but I doubt it will once the market recovers. Before you lock up that cash, make sure you’re very comfortable with this tradeoff.