WEALTH Matters — FALL 2009

Interest rates

Interest Rates on GICs and bonds have decreased again since our Summer issue. Here is an updated graph comparing 1-5 years rates with rates this summer and last summer. Without inflationary pressure, there is little likelihood of significant increases in interest rates for the next year.

A low rate environment causes two main problems for GIC investors who depend on interest income, as noted below.

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THE RECESSION HAS ENDED?

INterest rates

Investment Markets

TFSA STRATEGIES

Also in this issue of Wealth matters:

THE RECESSION HAS ENDED?

Investment Markets

TFSA STRATEGIES

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GIC Ladders

Most of our clients investing in GICs use a GIC Ladder: a series of 5-year GICs with their maturity dates staggered over time. We’ve written about this approach several times before. When rates are low there is a tempation for clients to abandon their GIC ladder and invest for short terms hoping that rates will increase.

Unfortunately, trying to time the market rarely works according to research by Crestmont. If you decide to take a 1-year term at 1.55% instead of the current 5-year rate of 3.3%, then you’ll be 1.75% behind in a year’s time, which you would need to make up over the next 4 years. The 4-year rate would need to rise from its current 2.95% to over 3.7% in one year for you to be able to break even at the end of the 5-years. If rates don’t go up as quickly, your shortfall will only get bigger. Maintaining your 5-year ladder is much less complicated, and has proven to be a reliable way to maintain a high average return even when interest rates are changing.

Depletion of Capital

Most investors don’t want to use up their capital to make up the income reduction from lower interest rates. But because of the low inflation which normally accompanies low interest rates, using up some capital will usually put you in the same end state.

Why?

To understand this we need to examine the relationship between inflation and interest rates, and the impact of inflation over time. The graph shows interest rates and inflation rates month by month since the 1950s. It is clear that interest rates are higher when inflation is higher. This is because investors demand a ‘real’ rate of return – the excess over inflation.

Let’s say inflation stays steady at 3% - the high end of the Bank of Canada’s target of 1-3%. Market interest rates for 5-year GICs would likely be 5-6% so that the after-tax return is about equal to inflation (this is the usual case except during the high-inflation 1970s and 1980s). If you maintained your capital and spent only your interest income, you would soon find that the cost of living has increased to the point where you need more income.

Your capital would have the same dollar value and the interest rate is the same, so you would need to start spending some of your capital to maintain the same lifestyle.20 years of 3% inflation compounded means the cost of living would be about 80% higher. The ‘purchasing value’ of your capital would be about 55% of its original value at the start. So even by not spending your capital, its purchasing value is declining because of inflation.

An alternate scenario has inflation at only 1%. Market interest rates would likely be about 3%. Since the interest rate is so much lower than in the first scenario, the investor would need to use some capital from the beginning to support the same lifestyle as with 5.5% interest.

In 20 years time, only 57% of the capital would remain, but the lower inflation rate has increased the cost of living by only 22% in 20 years, so the ‘purchasing value’ has declined to only 82% of its original value. 57% remaining capital times 82% purchasing value is about 47% of original purchasing value remaining. While this is lower than 100% of capital with 55% of purchasing power, the difference is not nearly as much as most people would guess. Tax effects would make the end results even closer, because more tax is payable when interest rates are higher.

In any case, the conclusion is that inflation will rob you of purchasing power even if you don’t spend your capital, and in a low inflation environment you can safely spend some of your capital and end up in about the same position.

One word of caution: get some help in forecasting this out for your own situation, and redo those forecasts from time to time to ensure that you don’t spend your capital so quickly that you may risk running out before your need for income has ended. We would be glad to help you with this.

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