Term Selection for
Investors: The Winning Strategy Term Selection for
Investors: The Winning Strategy
From the perspective of the investor who does not have to worry about liquidity, the most appropriate term strategy for selecting a GIC is one which optimizes interest earned for a given period of time. In this analysis, we consider and compare on an historical basis, the outcome of two alternate term selection strategies.
Which strategy would have produced the best results for the investor? The "investor's lock-in premium" as illustrated in the chart, is a measure of the differential in the rate of return for an investor selecting a five-year term relative to a "rollover" strategy of continually going short.
How was this differential constructed? Using monthly data on GIC's over the period from 1965-1995, two investment scenarios were constructed. The first scenario was based on the five-year GIC rate.
The prevailing five-year rate for each month was used to calculate total interest accrued over the term of the GIC had an investor locked into the five year rate at each month over the 1965-1995 period.
The second scenario was based on the one-year GIC rate referred to as the rollover strategy. The rollover strategy assumes that the investor selected the one-year term and then renewed it annually at the prevailing one-year rate, for a five-year period. The amount of accumulated interest is the sum of interest accrued over a five-year period.
The "investor's lock-in premium" shown in the chart is the difference between the two scenarios as measured by the five-year GIC rate and the average of the one-year rates (for a five-year period), calculated for each month over a 30 year period. The higher the premium, the higher the relative rate of return from locking into a five-year GIC.
The chart illustrates that over that period under examination, the rate of return on locking into a five-year GIC term would have consistently exceeded that of investors who instead maintained a one-year term strategy. On average, the five-year strategy produced superior results 71% of the time, resulting in an average "premium pickup" of 97 basis points (see table below). This can mean an increase in term investment income of over 30% ( rate as of October 10 '96) based on today's one-year rate.
The magnitude of "investor's lock-in premium" has varied over time, influenced by prevailing economic and financial market conditions. The 1960's were characterized by a period of low inflation and interest rate stability, in contrast to the 1970's. Throughout the second half of the 1960's, the five-year strategy resulted in a premium over the rollover strategy 60% of the time. In the 1970's, the five-year strategy was best 50% of the time. The major factor effecting returns was the series inflationary oil price shocks in the second half of the decade. This precipitated an acceleration in inflation resulting in a prolonged period when short-term interest rates were higher than long-term interest rates as monetary policy tightened in response. Through this period, the five-year investor was at a disadvantage.
Since the late 1970's, however, the "investor's lock-in premium" has been almost consistently positive. In the 1980's the five-year strategy was best 85% of the time. The only time when the rollover strategy was somewhat advantageous was in the mid-1980's, when conditions similar to those which prevailed in the late 1970's occurred. During this period in the mid 1980's, an inverted yield curve preceded a prolonged period of rising interest rates. Investors choosing a rollover strategy were able to benefit from the steady increase in interest rates when compared to investors who had locked into five-year terms in the same period in the mid-1980's.
The experience of investors so far in the 1990's is similar to that of the 1980's - to date, the five-year term compared to the rollover has resulted in a premium enhancement averaging 2.35%. (It should be noted that adjustments have been made to the rollover strategy as September 1992 - 1995 are not counted as full five year cycles). For example, if a customer invested $10,000 in a five-year GIC in January 1990, the five-year rate was 10.3% and on maturity the investment would be worth $16,326. If the customer locked in the same amount for a one-year term and reinvested the principal and interest for five years, the average rate over five years would have been 7.56% and on maturity the investment would be worth $14,134.
The five-year strategy on average over a 30 year period produced a premium
for investors when compared to the rollover strategy. The exceptions to this
rule have been during periods characterized by high inflation and a subsequent
sharp tightening in monetary policy, such as that which prevailed during the
late 1970's and briefly again in the mid-1980's. The current economic outlook
supports a forecast of stable economic growth accompanied by moderate inflation.
This would suggest that investors can continue to expect a "premium pickup"
with a five-year strategy compared to the rollover strategy at least for the
balance of the decade.
Back to the Consumer Finance Page
Back
to the Mary McDonough Research Associates Homepage
Return to The Homepage