Government Bonds vs. GICs: What’s Better?

Investors who are looking for fixed-income exposure have a variety of options available to them. For people interested in safer fixed income offerings in Canada, there are a few choices.

One possibility is to buy federal or provincial government savings bonds. These come with very low interest rates (0.5% to 1% is common these days), but are legal obligations of the governments that issue them. So long as the government doesn’t default on the debt, there’s no risk of losing money (that said, with yields so low, the inflation-adjusted return is actually negative).

But as we’ve explained previously, there are really two kinds of government bonds. In addition to savings bonds, there are also bonds that are actively traded among market participants. These are the bonds whose prices and yields are regularly quoted on the news and in the financial media. They are another option for a fixed-income investor. Common maturities for these bonds are five, 10 and even 30 years.

As with savings bonds, these actively traded securities are legal obligations of the governments that issue them. So if you hold them to maturity, you’ll get your money back plus interest (again, assuming there’s no default; Alberta is the only province that’s ever defaulted on its debt, which happened during the Great Depression).

But here’s the difference between savings bonds and these other kinds of bonds: There’s the potential for capital gains or losses. For example, if you buy a Canadian government bond and interest rates on comparable securities decrease, the bond you own will rise in value. To understand why this is the case, imagine that the bond you own pays 2% interest. But then if rates fall and newly issued government bonds only pay 1.5%, you can see how a 2% bond becomes significantly more attractive. So what investors will do is “bid up” the price of the 2% bond so that its effective (current) yield is actually closer to 1.5%. And if you sell your bond before maturity, you’ll record a capital gain because you’ll be able to sell it for a higher price on the open market.

Of course, the reverse can happen. You can buy a bond and interest rates can rise, which will then send the price of your bond falling in value. The logic is the same: A bond that has a 2% coupon won’t be very attractive to investors if yields on newly issued bonds are higher. To compensate for this, the price of the 2% bonds will decrease. And if you sell before maturity, you’ll incur a capital loss.