Building GIC Ladders for Daily Spending

Rising interest rates on bonds and the central bank overnight rate may have held down your bond returns in the past year, but there is a silver lining.

All of a sudden, when it seemed like interest income was forever lost, your cash is finally worth something again.

Since the Financial Crisis in 2008-2009, money in the bank has returned essentially nothing. Even so-called high interest savings accounts paid a pitiful 0.5% interest while inflation roared ahead at 2% per year or more.

The cautious folks in this world who used to count on 3% or higher interest income have taken massive financial hits this past decade thanks to an ugly combination of no interest income paired with erosion of spending power.

Retirees have been stuck depleting their savings while expenses were steadily climbing. But this is finally turning a corner thanks to the recent rate hikes.

On this blog I talk a lot about ETFs, stocks, houses, and bonds. But so far I haven't said much about cash in the bank.

I think cash plays an important role in your overall financial health. Especially if you are retired and living off your assets.

Although most of your assets should be hard at work in stock and bond ETFs, it is important to have a moderate amount of cash set aside for daily living expenses.

This can help you reduce stress during portfolio drawdowns and while ensuring your portfolio recovers with the market. Portfolios recover from drawdowns quicker when you are not taking equity away from them.

One of the better ways to hold cash is by using high interest GICs.

GICs (Guaranteed Investment Certificates)

A GIC is locked-in loan you make to a bank for a specified term. It's the Canadian version of the American CD (Certificate of Deposit).

The terms for GICs in Canada generally range from 3 months to 5 years. The longer the term, the higher the annual interest rate should be.

Since GICs are a locked-in loan, if you ask for your money back early, you typically will pay steep penalties to the bank. Those penalties can be equal to or higher than the interest you should have earned on your GIC for the entire term!

GICs can be held in every type of investment account (TFSA, RRSP, RRIF, and non-registered accounts).

For tax and investment efficiency reasons, I would say it is best for most people to hold their GICs inside their RRSP, particularly if they only have investments in RRSPs and TFSAs.

If you have money outside of your registered accounts, it could make sense to hold some GICs in a non-registered account.

GIC interest income is classified as "Other Income", so it is not necessarily very tax efficient. But generally the income generated by GICs wouldn't be that high.

That is if you are using GICs appropriately to form a small part of your overall portfolio.

Understanding the "Guaranteed" Part of GICs

A GIC, or combination of GICs at the same bank, up to C$100,000 is not only "guaranteed" by the bank, but ultimately backstopped by the Canadian Deposit Insurance Corporation (CDIC) if the bank fails.

The guaranteed part is important to understand. For all intents and purposes, a GIC is as good as a government bond since the CDIC is a federal Crown corporation.

But there are some important caveats.

  • CDIC will only cover an amount up to $100,000 per account type, per institution.
  • CDIC only covers products with terms equal to or less than 5 years.
  • If the bank fails, count on it taking a long time to get your money back through CDIC.

There are strategies you can use to address some of these issues. First, if you plan to have more than $100,000 in GICs, you will need to use more than one banking institution.

Simply buy part of your overall GIC holding at one bank and part at another with each bank having less than $100,000 worth of GICs.

Bank loyalty or a slightly higher interest rate at your preferred bank is not good reason to subject your investment to banking risk!

The next part is easy, buy GICs with terms less than 5 years. As best I can tell GICs are only sold with terms up to 5 years, so this should not be an issue. You should also question the benefits of holding 5 years worth of cash.

Finally, it rarely hurts to use more than one bank. Your odds of having all your cash tied up in a CDIC boondoggle are lower if you spread your GICs across two different banks.

Setting Up a GIC Ladder

Most investors who use GICs as a place to put aside living expenses will set up what's called a GIC Ladder.

This is a strategy where the retiree buys several GICs with different expiry dates. The goal is to release money for spending at regular intervals without paying penalties to get your money when you need it.

For example, if you want to have 3 years of living expenses set aside (probably at the higher end for a typical retiree), you might choose 3 different GIC terms to get started.

First, keep some cash in a savings account for the first 6 months of spending needs.

Next, buy a 6-month GIC to cover your spending for the period 6 to 12 months from now.

Next, buy a 1-year GIC to cover spending for the period 12 to 24 months from now.

Finally, buy a 2-year GIC to cover spending for the period 24 to 36 months from now.

As long as your investment portfolio is doing reasonably well, continue buying 2-year GICs every six months. This ensures you will get a fresh stream of GICs expiring every 6 months providing future spending money for you.

The only exception is during a market crash. If your stock portfolio is down more than 20% (indicative of a bear market), hold off on buying new GICs until the market recovers.

It is important to remember that the relatively small amount of interest a GIC pays typically won't grow your wealth. But it will cushion much of the creeping costs of inflation and maybe provide a tiny profit.

Make sure you shop around for a good rate when buying GICs and building your GIC Ladder.

Stick with CDIC insured banks for safety, but don't run into your big bank and think they will pay a competitive interest rate to you. Generally the second tier federal banks are a better choice.

Right now, second tier federal banks like EQ Bank, Oaken Financial, and Haventree yield between 2.5% - 3% annual interest for a 2-year GIC.

That's not a bad rate considering our current inflation rate is a little under 2.5%.

Keep in Mind

There are many ways to protect your portfolio in market downturns—GICs are a small part of the total portfolio structure. The main objective of GICs is to try not deplete your portfolio for spending needs when you are in a large drawdown.

We mainly protect our portfolios through diversification with stocks, foreign stocks, bonds, precious metals, or maybe even real estate.

High quality short-term bonds, long-term government bonds, and gold can do very well when stocks are suffering.

Alternatively, you can use a more active, but highly disciplined investment approach to protect the downside. Dual Momentum and trend-based strategies are great for this!

It can also be very beneficial to split your portfolio into two different strategies. Put half of your portfolio in a passive strategy and half in a systematic active strategy.

However, don't put too much money in GICs. If you are a nervous investor it is almost certainly better to increase your bond allocation. Bonds will always provide higher returns than GICs over the medium term.

Before allocating money into GICs based on your spending needs, remember to calculate your other income and deduct this from your spending needs.

If you spend $20,000 every 6 months, don't just buy $20,000 worth of GICs every six months. Instead, deduct your CPP/OAS income, deduct any dividend and interest income generated by your portfolio, and deduct any employment or other income.

Once this is all done, chances are you will need less than $10,000 every 6 months from your GICs.

When interest rates on GICs are around the inflation rate, GICs are a great way to have some cash set aside for spending that earns some interest.

But when GICs are paying way below the inflation rate, avoid them and look to other options instead. It is not worth having your money locked up in a negative real return for years.

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Is It Time to Buy?

Before we get into this post, I just want to thank the readers who contacted me about the comment verification plug-in failing. I've installed a new verification plug-in that seems to work well and is easier to read than the last one. Comments are back!

Canadians love housing! For nearly two decades now, housing has been the economic story in Canada. Thousands of us have become fantastically rich on paper as prices of tiny lots and chipboard went to the moon.

Of course ridiculous amounts of leverage helped. Prices have only about doubled in the past 10 years, but at a 19:1 leverage ratio the gains on equity appear enormous!

The real estate pushers got really rich! With billions of dollars of housing changing hands each year and 4-5% of that for grabs in sales commissions, these folks have made hay.

When times are good, thanks in large part to horrible government policy, the pushers celebrate the rising "natural" condition of the market.

When prices begin to fall, thanks again in part to horrible government policy, these same middlemen furiously point fingers.

An Update on the Market

Well, at the end of summer 2018, prices and sales volumes are falling in nearly every major Canadian housing market. Things are not looking good at all for sellers or people who extended themselves to buy real estate.

Toronto and Vancouver, the two big Canadian market movers, have seen a massive sales collapse in their single family markets. Sales=to=listings ratios have exploded. We are now in what the pushers call a "buyers market". But that doesn't mean it's time to buy!

Prices are slowly falling alongside, but the real reckoning hasn't started yet. The condition of these big markets reminds me of the Prairie markets back in 2015. Eyes have not been opened yet.

For example, the largest Prairie markets, Calgary and Edmonton are continuing their multi-year price slide across the board. The slide began with low volume and isolated good deals, particularly in the condo space. But it has spread and the price concessions are growing rapidly.

Although the house pumper MLS numbers seem to paint a rosier picture, units in my townhouse complex are selling for almost 20% lower than their brand new price seven years ago! Single family houses in Edmonton that sold for $500,000 ten years ago are now selling for $400,000.

Factors Driving Real Estate Prices

As I've stated before on this blog, house prices are primarily the result of interest rates and household income. With a dose of consumer optimism or pessimism to extend the market one way or another.

Household income needs to expand over time to see an increase in house prices beyond the normal rate of inflation (1-3% per year). In the short term, a fall in interest rates can expand borrowing capacity leading to higher prices while a rise in interest rates leads to price compression.

If the Canadian real estate markets were solely dependent on household incomes, the price of a house would be around $290,000 today. That's if Canadian households spent 20% of their income on mortgage costs (the historical long-term average).

Higher income regions like Toronto, Calgary, and Edmonton would see higher house prices. Same goes for areas that appeal to high net worth individuals, certain areas in southern B.C. for example.

However, it does not explain an national average house price of $630,000. These insane valuations are not economically justifiable in our current circumstance.

No region of Canada is even remotely comparable to the world's higher priced regions like Hong Kong, New York, San Francisco, Singapore, or London.

These are the finance, culture, and industry capitals of the world, filled with millionaires and billionaires who can afford expensive homes. And they are not millionaires just because their houses have increased in value, I'm talking real financial assets with the representative income.

Where Things Are Going

Our house price explosion is purely due to a combination very ominous factors. Record household debt and leverage ratios, extremely relaxed borrowing standards for over ten years, reckless government policy support, and a population that is convinced housing is a get-rich scheme rather than a roof over your head.

These big, long-duration parties come with nasty hangovers, and don't be fooled: no party lasts forever.

Over the past few years an untold number of Canadian families have taken on mortgages of $500,000 or more. The monthly payments are approaching $2,700 at today's best discounted rates. As rates creep up over 4% (yes, it seems to be happening), those payments will balloon over $3,000 a month.

Did I forget to mention, that is after-tax money. If you are earning in the 40% tax bracket, you need to earn a gross income of $5,000 just to pay the mortgage.

Those who took on these monster mortgages when the 5-year fixed rate was less than 2.5% will be shocked when they renew at the end of their terms. They will have a choice of paying at least $500 more per month for the same mortgage, or, if they are lucky, refinance and stretch out the term to keep the payments low.

Already a few years ago, deep-diving economists were raising alarm bells about borrowing. There are more than 1.8 million households with monthly mortgage payments exceeding 20% of their net household income. This group has an average savings rate of -13% of their household income.

The evidence suggests at least hundreds of thousands of households across Canada are perpetually dipping into household equity, or accumulating other debt. Canada might not be the U.S.A., but it turns out people are behaving the same here as the Americans in the 2006-2008 period.

I believe many who already stretched themselves farther than they should have will be forced to sell. If I'm correct, we may be looking at an American-style downward spiral right here in Canada... where no Canadian thought it could ever happen.

Comments & Questions

All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.