Term Selection For Investors: The Winning Strategy

Editor’s Note: This article was written in 1997. Although the market context was the 30 years from 1966 to 1996, the investment climate was generally the same as now. Interest rates were falling over most of the period and only rose occasionally when monetary policy was tightened.

Investors in Guaranteed Investment Contracts (GICs) are continually faced with the dilemma of the appropriate term selection: should they lock into a longer term such as a five-year GIC or should they choose a short-term GIC?

As in all things Financial Pipeline, the answer lies in the evidence. We compared a hypothetical investor who had continually taken a short-term GIC with an investor who had locked into a five-year term. The results were conclusive, over the 30-year period between 1965-1995, rolling over five-year GICs would have produced the better investment result.

Even today, investors considering their course of action in today’s investment climate, these results provide guidance. 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 that maximizes the interest earned over a given period of time.

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, based on monthly data for GIC’s over the period from 1965-1995.

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. We assumed the investor had locked any cash flows received at the five-year rate 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 would be the relative rate of return from locking into a five-year GIC rate.

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% or 97 “basis points”, as seen in the table below). This would mean a 30% increase in the interest income (rate as of October 10, 1996) based on the 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 1960’s, 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 effecting returns was the series inflationary oil price shocks in the second half of the decade. This precipitated the 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 that 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.

Editor’s Note: This analysis was originally done in 1996 and references the situation at that time. The conclusions are still generally sound, for two reasons:

  1. Interest rates have been generally falling for the 18 years since 1996. Locking in the higher interest rate for longer would have resulted in higher interest income; and
  2. The yield curve was “positively sloped” for most of the period, meaning the 5 year GIC rate would have been higher than the 1-year GIC rate.

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 those that prevailed during the late 1970s and briefly again in the mid-1980s. The economic outlook at the time supported a forecast of stable economic growth accompanied by moderate inflation. This would suggest that investors could 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.

6 years ago