The surge in interest rates over the past year has given investors more options to generate attractive income on savings. Retirees looking for passive income are wondering if it is better to own Guaranteed Investment Certificates (GICs) or top TSX dividend stocks inside a self-directed Tax-Free Savings Account (TFSA) today.
Why are GIC rates rising?
The Bank of Canada is trying to get inflation back down to 2% after a hot post-pandemic economy triggered a surge in inflation to 8%. In order to hit the inflation target of 2%, the central bank needs to cool off the economy and bring the employment market back into balance. Raising interest rates is the preferred tool to achieve the objective.
Higher borrowing costs cut into profits for businesses and reduce the cash that households have to spend on discretionary purchases. As spending slows down, businesses should be less inclined to increase prices and won’t need as many workers.
The flip side of interest rate hikes is that banks can now offer much better rates to people with savings. At the time of writing, GIC rates of 5.5% to 5.75% are available for a one-year term, depending on the issuing financial institution. That is an attractive return for an investment that has zero risk for the investor as long as the GIC is from a Canada Deposit Insurance Corporation (CDIC) member and the amount is within the $100,000 limit.
The downside of a GIC is that the invested funds are not accessible until the GIC matures. Investors who don’t have other funds available to tap for an emergency might want to keep GIC terms short or at least ladder them so that there are GICs maturing every few months. Rates are also fixed for the term of the GIC. In the current environment, rates are high, but it is likely that the Bank of Canada will have to lower interest rates in 2024 or 2025 to avoid driving the economy into a severe recession. As interest rates fall, GIC rates will likely decline in step, so the rate an investor might get on renewal of the GIC could be much lower.
Why are dividend yields so high?
The share prices of many top-quality Canadian dividend stocks have declined considerably over the past year, largely as a result of the surge in interest rates. Stocks carry risks, so the market demands a higher dividend yield than the rate offered by a no-risk alternative. All things being equal, as rates on GICs and fixed-income investments rise, stock prices would be expected to fall, pushing up dividend yields.
Investors are also concerned that higher interest rates will hurt profits and reduce cash available for dividend increases. Communications firms, pipeline companies and utilities, for example, all have large capital programs and use debt to fund their growth initiatives. As borrowing costs increase, there can be a negative impact on the bottom line.
In the case of financial stocks, the surge in interest rates is expected to drive up defaults on loans held by customers with too much debt. At the same time, higher interest rates tend to have a negative impact on demand for new loans as businesses shelve expansion projects and fewer people are able to qualify for mortgages and loans for other purchases.
As long as interest rates continue to move higher, dividend stocks are likely to remain under pressure. That being said, as soon as interest rates begin to decline, there should be a rebound, and it could be a significant move to the upside over a short period of time.
Are dividend stocks or GICs now attractive?
GICs deserve to be part of the mix at current rates as a way to get good returns and reduce portfolio risk. Contrarian investors who can handle some volatility might want to start buying shares of top dividend-growth stocks while they offer high yields. Enbridge and Telus, for example, have increased their dividends annually for more than two decades and now offer dividend yields of 8.1% and 6.4%, respectively.
At the very least, the distributions should be safe in these stocks, and you’ll get paid well to wait for a rebound.
In today’s market conditions, it would make sense to split a new TFSA investment between GICs and high-quality dividend stocks to reduce risk while bumping up the average return in the invested funds.
