Reserve Funds and Reserve Fund Studies
Investing the Reserve Fund – Part 3 – GIC Strategy
From the Fall 2023 issue of the CCI South Alberta CCI Review
INTRODUCTION: Parts 1 and 2 of my article “Investing the Reserve Fund” were published in the Spring and Summer editions of this CCI Review newsletter. These articles covered the Condominium Property Act (CPA) legislative backdrop which regulates reserve fund investments and the importance of condo corporation (Corporation) investment policies, objectives and strategies. I also covered how, practically, to implement your investment policy by establishing investment tranches for your reserve fund plan based on CPA approved asset allocations for common stocks, preferred shares, bonds and guaranteed investment certificates (GICs). Finally, I covered some of the complexities of investing in these financial markets and explained the need for retaining an investment professional to guide a Board through the development of an investment portfolio. Here now is the final Part 3 of “Investing the Reserve Fund” which will focus specifically on developing a GIC investment strategy and portfolio and some details for implementing a simple but powerful laddered GIC investment strategy.
Investment Strategy For GICs
Probably the most popular strategy for GICs is the Laddered GIC Investment Strategy. This strategy is simple but powerful and doesn’t need an expert to implement it, though some financial expertise is helpful if a more complex set of policies are placed around the GIC portfolio. Laddering is powerful since interest rates are generally higher for longer terms to maturity and this results in a higher average rate of return for the portfolio. These higher interest rates in future years can be plotted on a graph and the curve created is called the yield curve. However, in rare circumstances, this yield curve can be negatively sloped where future interest rates are lower than earlier years. Your investment advisor can provide advice on terms to maturity based on the reasons for the shape of the yield curve.
Laddering means to start a portfolio by investing about 20 percent of it for a one year term to maturity, about 20 percent for a two year term and so forth to about 20 percent for a five year term. Five years is the maximum term used in most cases because this is the maximum term that is guaranteed by the Canada Deposit Guarantee Corporation (CDIC). For example, if you have $500,000 to invest you would invest $100,000 to mature in each future year to year five (see table 1):
As shown in the above table, the interest rates get larger as your maturities go out further in time. The interest rate for a five year GIC in this example is 6.00% compared to the interest rate for a one year GIC of only 4.50%, a difference of 1.50% or $7,500 more in interest income for the five year term of this investment. In each subsequent year you can then invest the maturing GIC for up to five years and if interest rates were to stay the same you would then get a 6.00% return for this GIC. If interest rates increase you will get an even higher return and if they decrease you will have locked in the higher return for the other 4 years. Always check the yield curve when you are rolling over an investment because there can be anomalies and you should take advantage of these anomalies. You could, with these anomalies, ‘ride the yield curve’ but this strategy is beyond the scope of this article. You should ask your investment advisor about this.
An added benefit of the laddered GIC investment strategy is the liquidity this portfolio gives you. Every year you have about 20% of the portfolio maturing to provide cash to supplement the net contributions to your reserve fund, or to provide for the net expenditures from the reserve fund in that year. If you know that you will have a cash shortfall in the reserve fund in year three of the plan you can plan to have more in GICs mature in that year and less in other years. Alternatively, you may have already provided for a cash shortfall in year three by having your non-GIC investments mature in that year. This gives you total flexibility to manage the cash/liquidity requirements of your reserve fund from multiple tranches of your investment portfolio.
Credit Quality of the GIC Portfolio
Your GIC policy should cover the credit quality of the banks, trusts and credit unions that will be invested in. Since virtually all of Canada’s federally regulated chartered bank and trusts’ deposits are guaranteed to $100,000 by the CDIC, there is little to worry about with GICs if you allocate no more than $100,000 to each of these financial institutions. Obligations of the CDIC are guaranteed by the Government of Canada as an agent of the Crown and thus has a AAA credit rating, Canada’s and the world’s best credit rating. Your GIC portfolio strategy should take advantage of the CDIC guarantee by investing first in the GICs of the poorer credit quality banks and trust companies whose deposits are guaranteed by the CDIC. Check with the CDIC website to make sure the deposits of the bank or trust are indeed guaranteed by them. These banks and trusts pay higher interest rates than better credit quality banks and trusts so you will be relying on the CDIC guarantee of up to $100,000 (principal and interest) to ensure the safety of your investment. Limit your investment in these banks and trusts to $90,000 each to make sure your accrued interest is equally guaranteed.
Turning to credit unions and other provincially regulated financial institutions, these deposits are not guaranteed by the CDIC with minor exceptions. Virtually all credit unions are provincially regulated and because of this deposits in credit unions are guaranteed by provincial deposit guarantee corporations. The amounts and strength of these guarantees thus vary province by province. In Alberta, the Alberta Credit Union Deposit Guarantee Corporation is well capitalized and the Alberta Government guarantees 100% of Alberta credit union deposits with a hard guarantee contained in the credit union and related acts. Notwithstanding this, it is prudent to diversify your GIC portfolio with some investments made outside the credit union system. This is because Alberta’s credit unions have, as a group, had severe financial difficulties in the 1980’s with many credit unions being amalgamated to enable the system to survive. No deposits were lost at that time but a diversified investment portfolio would have made many condo directors sleep better at night.
As your GIC portfolio gets larger at or above $1.5 million you will find it hard to find higher return GIC investment opportunities and you will run out of banks and trusts to invest in at $100,000 per bank/trust. Your investment policy should provide for investing more than $100,000 only in financial institutions that have an ‘A’ or better credit rating. ‘A’, ‘AA’ and ‘AAA’ ratings are strong investment grade credit ratings. Remember that if your banker is a federally regulated financial institution then your bank account balances are also CDIC guaranteed to only $100,000. Be sure that these balances are included in your calculations for bank credit risk exposure and that your banker has an ‘A’ or better credit rating if your total bank and GIC balances exceed $100,000.
In this Part 3 of “Investing the Reserve Fund” I have covered how to develop a GIC investment strategy and portfolio, have provided details for implementing a simple but powerful laddered GIC investment strategy and have provided a sample GIC laddered investment portfolio. This ends my three part series.
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