TD Bank’s 5-Year Stepper GIC 2008 is the third choice. In part 1 & 2 of this series, I described what I thought was the first & second best investments (investment decisions) that I have made within the past decade. Some of you will be curious as to why I picked this as my third best over other higher returning investments.
Again in evaluating which investments/decisions I think have been the best, I did not measure/compare them based solely on yearly performance numbers, and instead took an overall evaluation approach. The role the investment plays in the overall plan, the individual valuation/price, and other criteria were considered.
Please keep in mind that NONE of my selections are investment recommendations. PLEASE do not rush out and blindly acquire the investments mentioned without any planning, research, or analysis. This should be considered a case study, so readers can see the thought and decision making processes I went through in the situations that occurred. Giving theoretical examples serve only to illustrate concepts & ideas, but discussing experiences (as in case studies) are more useful in showing exactly how the concepts & ideas can be applied to a real life situation. I hope the experiences can help other investors when presented with similar situations and opportunities.
The Investment [TD Bank 5-YEAR STEPPER GIC 2008]:
I purchased TD Bank’s “5-Year Stepper GIC 2008” in May 2008. The payment scheme of the Guaranteed Investment Certificate (GIC) was:
1.8% for the 1st yr (May 2008 – May 2009).
3.4% for the 2nd yr (May 2009 – May 2010).
4.0% for the 3rd yr (May 2010 – May 2011).
4.5% for the 4th yr (May 2011 – May 2012).
8.0% for the 5th yr (May 2012 – May 2013).
Effective annual yield = 4.32%
The Financial Crisis:
The investment was purchased at the onset of the bank failures during the financial crisis & US real estate meltdown. Stock market indices across the globe had plunged, and residential & commercial real estate prices across the United States plummeted. A few months earlier (3/16/2008), investors had witnessed the collapse of Bear Stearns. It was the first major financial institution to fail in recent history, with many more to follow that year. Banks across the globe and especially in the US had just started to show the first wave of severe loan losses.The Federal Reserve had quickly backed a deal that would see Bear Stearns be absorbed into JPMorgan Chase in a fire sale, with $30 billion from the government to cover its losses in an attempt to head off more failures.
The government had yet to make any broad sweeping changes or modifications to monetary policy. Everyone was hoping that the financial system would remain relatively stable.
Low Rate Environment Was Likely To Come:
The investment was made with the high probability that rates were going to drop. Prior to the crisis in early 2007, indications of an impending downturn had already appeared. This included numerous factory closings across America, which would translate into manufacturing job losses. The auto sector which had employed 1 out of 3 jobs in the U.S., had also announced planned plant closings.
The Bear Stearns collapse indicated that more bank failures were likely, and that a major economic downturn was to come. However, the full effects of a slowdown were yet to be felt by the economy, even though real estate prices had already started to plummet in the U.S. The U.S. and Canadian economies are closely tied, and any economic downturn in the U.S. would definitely affect Canada.
Rates were very likely to drop in order to stimulate the economy and lending, if a slowdown was to occur. Even though the effective annual yield/rate would only be 4.32%, rates were not likely to be favorable going forward for the next few years. It was expected that in the following years, we would not see 5 year GIC rates, or 1 year rates (if invested every year for 5 years), that would be even close to an effective annual yield of 4.32%.
The Economic Downturn:
In September 2008, the failures continued and produced fears of a liquidity crisis that wasn’t seen since the Great Depression. Fannie May and Freddie Mac were seized by the government (9/7/2008), while Northern Rock was given funds by the Bank of England (9/13/2008) to avert a run on the bank. The failures of Merrill Lynch, Lehman Brothers, AIG, Washington Mutual, and Wachovia shortly followed, all within the month of September. U.S. president George W. Bush signed the Emergency Economic Stabilization Act of 2008 into law on October 3, 2008, to address the sub-prime mortgage crisis. The act was the first bailout of the U.S. financial system for the recent financial crisis. It authorized the United States Secretary of the Treasury to spend up to US$700 billion to purchase distressed assets, especially mortgage-backed securities, and to make capital injections into retail banks.
As a result, credit & lending tightened, creating liquidity problems. Retail banks that had survived started to hoard cash. Corporate debt refinancing became a problem and the private sector in-turn began to hoard cash as well. The global economy contracted severely, and central banks around the world were forced to lower rates. In Canada, retail bank rates dropped significantly around January 2009, and continued to decline to historic lows.
Impact & Additional Thoughts:
This investment serves as a reminder of how important it is to understand how an asset works and the economics affecting it. This knowledge allows one to better compare an asset against other similar alternatives. In this case, the comparison is of the 5 year stepper (laddering) GIC versus the alternatives of investing in a regular 5 year GIC, 1 year GICs for 5 years, or a savings account for 5 years.
When assessing the alternatives, the tradeoff of locking funds into the investment for 5 years at known rates can be weighed against allowing rates to float and change every year (1 year GICs) or more frequently (savings account). Locking into a fixed rate for 5 years, limits exposure to higher rates, if rates were to increase significantly during the following 5 years. This is where understanding the underlying economics affecting the asset makes a significant difference.
For this particular situation, the economics relate to monetary policy regarding rates, and the factors that affect them. At the time of the investment, it was reasonably expected that GIC rates would become much lower and remain low for an extended period of time (at least 5 years), for both the 5 year GICs and 1 year rates. Knowing this information, a sound investment decision could then be made by looking at the effective annual yield and taking the economics into consideration.
This situation also illustrates the importance of trusting the results of your own analysis & data, and what it tells you. At the time, the idea of retail rates declining to significantly low levels was not considered likely, nor was it talked about in the media as something that was expected to occur. Although it is often good to take outside information into consideration in order to test the validity of your own analysis, investment decisions should only be made based on sound analysis. It should not be made based on comments or behaviour from the media, analysts, other economists, and investors. In this case, the economics did not support rates being sustained at those levels.
In general, by sticking to what your data and what you know (if valid), it allows you to make unbiased investment decisions. Such decision making is important, because by the time everyone starts talking about something, its usually too late. In this case, by the time everyone started talking about rates dropping (late 2008), it had already dropped. The yields were no longer offered. In most cases, by the time the masses realize something, the best opportunity (or largest margin) will have disappeared.
How Is The Investment Doing Today?
Since the time of the investment, rates have dropped to historic lows and still remain very low today. This year, the investment is due to pay 4.5% of this year’s renewing amount, with the following final year due to pay 8% on that year’s renewing amount.
Today’s 5 year GIC rates are around 2.10%, and a similar stepper GIC is offering an effective yield of 2.297% (with a rate of only 3.8% in the 5th year). Current 1 year rates are around 1.15%. The current available rates are much lower than the 4.32% effective yield that the investment provides.
Looking at ING’s historical GIC rates and savings account rates helps to better illustrate the difference over the length of the investment. ING and other discount banks usually give higher interest rates (about 0.006% or more), so it will make the comparison even more interesting.
1 year GIC rates:
Mid 2008 was 3.50%
Mid 2009 was 1.50%
Mid 2010 was 1.75%
Current 2011 is 1.75%
Therefore had I invested in a 1 year GIC and renwed it each year (for 5 years), I would need the rate in 2012 to yield 13.6% in order to achieve a 4.32% effective yield!
5 year GIC rates:
Lets get creative and suppose that each year for 5 years, the bank was able to offer the rates from a 5 year GIC (instead of the lower rates from 1 year GICs):
Mid 2008 5 year rate was 4.00%
Mid 2009 5 year rate was 3.00%
Mid 2010 5 year rate was 3.25%
Current 2011 5 year rate is 3.00%
Therefore I would need the rate in 2012 to yield about 8.46% to match the 4.32% effective yield!
Savings account rates:
Mid 2008 was 3.00%
Mid 2009 was 1.50%
Mid 2010 was 1.50%
Current 2011 is 1.50%
Therefore I would need the rate in 2012 to yield about 15.1% to match the 4.32% effective yield!
We can see that the alternative investments choices at the time (May 2008) would not have been as profitable. Given today’s current rates, the 2012 rates are very unlikely to be high enough to match the effective yield of TD Bank’s 5-Year Stepper GIC 2008.
Why Was It One Of The Best?
Why would I consider this investment decision so much better than say a stock that returned over 700%? One reason is because guaranteed investments of an investor are just as an important as non-guaranteed ones. Investors tend to place too much emphasis on their non-guaranteed investments without attempting to maximizing the returns of the risk-free ones, which are often forgotten. By looking to maximize the returns of all their investments (including risk free ones), overall performance and returns are higher on a more consistent basis.
This investment also shows how the conventional risk vs return principle is not accurate. By the end of 2012 the stepper GIC would have a much higher return relative to what a traditional 5 year GIC would be able to return. It would also have a higher return than investing into 1 year GICs (every year for 5 years) or a savings account (for the full 5 years). This shows that you don’t need to add unnecessary risk in order to increase value and build wealth. No additional risk was incurred with this investment. A GIC has zero risk of loss directly associated with it.
The returns of the alternative investment choices at the time simply cannot compare. Also, there is no other investment that is federally backed by the Canada Deposit Insurance Corp, that will give a guaranteed return of 4.5% in 2011-2012, or a yield of 8.0% in 2012-2013.
Thanks & Happy Investing! — The Investment Blogger © 2011