GICs as Bond Substitutes?
Peter E. Bowles, CEBS, President and Robert J. McEvitt, Sr. Vice President and Portfolio Manager

By the middle of June, interest rates had fallen to a 45 to 50 year low and many observers were shaking their heads and wondering how much lower they would go. Some experts were talking about the spectre of deflation and their expectation that the Fed would drop the Fed Funds rate as much as 50 basis points to ward off Japan style economic doldrums. There was even much speculation about how much lower the Fed might be willing to go even after the expected June cut. However, the Fed dropped the Fed Funds rate only 25 basis points in late June rather than 50, and instead of rates going even lower from mid-June, we have experienced a phenomenal increase of as much as 114 basis points in the 5-year Treasury as of the writing of this article. Where will rates go from here and how much no one really knows, but many "experts" have opinions. Are the opinions expressed today worth any more than the ones we heard just eight weeks ago?

In the meantime, bond managers are confronted with the challenge of where on the yield curve to invest and in which market sectors. The BIG (Broad Investment Grade) index declined as much as 3.4% for the month of July alone and as much as 3.6% from mid-June to the end of the first week in August. If bond managers act defensively and shorten their portfolios dramatically to limit capital losses in the event of continuing interest rate increases, they will miss a comparable amount of gains if instead rates were to change course and drop again to the level of mid-June or below. Conversely, if fixed income managers stay fully invested in the same type of securities reflected in the indices, their portfolios will experience continuing losses if interest rates continue their climb.

What should they do?

One of the strategies worthy of consideration is looking at GICs and Funding Agreements, as bond substitutes. (For the sake of simplicity, we will refer to these closely related products as GICs.) Even when marked to market, GICs can offer many advantages in a conventional bond portfolio. S&P's latest default study reveals that the insurance industry has the second lowest default rate of any of the industry groups followed by their analysts. Since the GIC issuing segment of the insurance industry is the highest quality part of the insurance industry, their default rate is even lower than the industry in general. Moreover, since GICs (and Funding Agreements) are considered policyholder obligations, in the historically very rare instance of a GIC issuer default, the vast majority of contractholders have received 100 cents on the dollar or even more, as contrasted with the typical recovery of 56 cents for conventional bond defaults, according to S&P.

In the meantime, GICs are likely to pay a higher yield than the most comparable bond of equivalent quality and maturity. After gathering data over the prior 16 years from the survey of GIC rates we compile each week for BARRON's, we compared that data with historic bond yields for the same dates drawn from the Salomon Bond Roundup and more recently Bloomberg. We found that the highest yielding five year GIC offered an average yield premium over the 16-year period of as much as 38 basis points above the closest equivalent AA bond. Even during the past year when rates have been so low, the GIC has still offered as much as a 21 basis point premium over the closest equivalent bond. As a percent of the very low current base rate, these 21 basis points represent an even greater spread than the 38 basis point long-term nominal spread.

In addition, conventional GICs do not subject the portfolio to either prepayment or extension risk. Admittedly, there are some relatively exotic contract forms which pay a premium over conventional GICs where the purchaser can knowingly take on prepayment and/or extension risks, but these contracts are rarely purchased and do not represent the mainstream. When interest rates were declining, prepayment was the risk that conventional bond managers needed to carefully assess and for which they needed to make sure their portfolio was being properly compensated. Now that interest rates seem to be on the rise again, fixed income managers are carefully assessing extension risk. Who wants to have to hold onto a 2.25% two-year security any longer than absolutely necessary if rates are rising? In any event, if GICs were employed as bond substitutes, neither prepayment or extension risk would be a factor.

Best of all, if GICs are used as bond substitutes in a defined contribution plan, they may be eligible for book value treatment rather than needing to be marked to market, thereby avoiding the capital losses which conventional bonds have been subjected to over the past 7 weeks and perhaps well into the future. If the GIC can satisfy the requirements of AICPA Statement of Position 94-4, the accounting rules will permit it to be carried at book value even if other assets within the same portfolio are marked to market. Long before the advent of 401(k), single fund profit sharing plans commonly used GICs as bond substitutes to moderate the volatility of equities. Generally 94-4 requires that the contract be held by a defined contribution plan and that plan participants be able to access their funds for all plan benefits (liquidations, transfers, loans, hardship withdrawals, etc.) at the same value used by the plan in valuing the contract.

GICs and other variants including Funding agreements have much to offer to fixed income managers even when interest rates are not rising, but under current circumstances, they represent an exceptional value.