Investors who use GICs as an investment instrument are continually
faced with the dilemma of the appropriate term selection. Should they lock
into a longer term such as a five-year GIC? Should they choose a short-term
GIC instrument? The following analysis addresses the issue of what the
optimal term selection has been by comparing the relative benefits of a
hypothetical investor who had continually taken a short-term instrument with
those of an investor who had locked into a five-year term. The results are
conclusive. Over a 30 year period between 1965-1995 the five-year term
strategy would have produced the optimal investment results. For investors
now considering their course of action in today's investment climate, these
results should prove enlightening.
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 a 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 1960s were characterized by a period of low inflation and interest
rate stability, in contrast to the 1970s. Throughout the second half of
the 1960s, the five-year strategy resulted in a premium over the rollover
strategy 60% of the time. In the 1970s, the five-year strategy was best
50% of the time. The major factor affecting returns was the series of
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 1970s, however, the "investor's lock-in premium"
has been almost consistently positive. In the 1980s the five-year strategy
was best 85% of the time. The only time when the rollover strategy was
somewhat advantageous was in the mid-1980s, when conditions similar to
those which prevailed in the late 1970s occurred. During this period in
the mid 1980s, 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-1980s.
The experience of investors so far in the 1990s is similar to that of
the 1980s - 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 1970s and briefly again in the
mid-1980s. 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.
This study was prepared by Mary McDonough
Research Associates on behalf of the Bank of Montreal. |