No one GIC strategy, such as laddering, is best in all kinds of rising interest rate markets. So you might as well use the strategy which makes the most sense to you, and therefore you will probably be more disciplined in adhering to it—never a bad thing.
With reasonable certainty that we are headed into a period of successive interest rate increases, GIC investors will increasingly be looking for the best investment strategy for deploying their funds within this asset class.
What are some of your choices? Let’s begin by talking about your time horizon. If it’s at least five years (GICs generally don’t go beyond that) there are several options. One is simply, of course, to buy a five-year GIC and be done with it, and then roll it over at maturity into the term of your choice at that time. We call this the ‘bullet’ approach, because you only take one shot at investing your money.
The idea behind a bullet approach is to exploit the fact that the yield curve at the time is normal, with the five-year rate being higher than the four-year rate rate, which in turn is higher than the three-year rate, and so on. Thus the investor can earn the five-year rate right now, and keep earning it for five years, while investors who commit to shorter terms get less, at least in the early years.
A second possibility is to buy a one-year GIC, even though your horizon is five years, and then roll it over into another one-year GIC at maturity. This is done five times in total. We’ll call this the ‘rollover’ approach.
The idea with the rollover strategy is that, if interest rates increase, you will be able to roll over at a higher rate in the subsequent period than you can get by committing to that rate right from the beginning. In other words, you expect that the one-year rate one year from now will be higher than the two-year rate is right now.
For example, let’s say interest rates at the beginning of the program are 2.15 per cent for a one-year GIC and 2.45 per cent for a two-year GIC. The rollover strategist would select the one-year GIC in the hope that one year later interest rates will be higher than 2.45 per cent; that is, his or her average two-period return will exceed the 2.45 per cent offered right from the get-go. And, over five years, the average return will be higher than the five-year rate originally offered.
The third possibility is called the ‘ladder’ approach. This involves spreading your money across all five maturities by putting 20 per cent of your money into each.
Under the ladder approach, at maturity of the one-year tranche the proceeds would be invested into a five-year GIC. Then, when the two-year portion matures, it too would be reinvested in a five-year GIC, ultimately to mature one year later than the five-year purchased the year before. Continuing on with this pattern, investors will perpetually have one-fifth of their money maturing every year. Those who choose to ladder their GIC money are essentially saying they don’t have any feel at all for future interest rate direction, and decide instead to take an average of the five rates offered.
Bullet, rollover or ladder?
If the question you have is which—the bullet, the rollover or the ladder—is best given a rising interest rate environment, unfortunately there is no pat answer. It really depends on the rates and the rate increases used in the sample scenario.
More precisely, if you put this question to a test, the answer as to whichever of the three approaches works best depends both on the magnitude of the rate increase you assume will happen each year, and the slope of the yield curve both before and after the rate increase.
To give you one example, if a relatively flat yield curve shifts upwards by a small amount each year, that’s one thing, and the ladder approach would be the best way to go. But if a relatively flat yield curve shifts upward by a larger amount each year, then the rollover strategy will prevail. A bullet strategy, on the other hand, works best when a steeper yield curve rises—or falls—by small amounts each year.
Our main point here is that no one GIC strategy, such as laddering, is best in all kinds of rising interest rate markets. So you might as well use the strategy which makes the most sense to you, and therefore you will probably be more disciplined in adhering to it—never a bad thing.
This is an edited version of an article that was originally published for subscribers in the December 1, 2017, issue of Money Reporter. You can profit from the award-winning advice subscribers receive regularly in Money Reporter.
Money Reporter, MPL Communications Inc.
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