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Why you shouldn't invest in savings bonds

If you invest $100 in the current Canada Savings Bond series, you will earn you a whopping 65 cents over the course of a year. Ouch.

Once you consider that inflation is about 2 per cent, you are actually losing purchasing power with such an investment, even if you hold it in a tax-sheltered registered retirement savings plan or tax-free savings account. Your $100.65 is now only worth about $98.64.

Just to be dramatic, let's pretend you are holding the bond in a non-registered investment account. Interest is taxed like regular income, so whatever your marginal tax bracket is, that's how much you will fork over to the taxman when you file your annual taxes. So if your marginal tax bracket is 46.41 per cent (the highest in Ontario - remember, I said I was going to be dramatic), then 30 cents of the interest you earned will be finding a new home. In this case, your $100 investment is worth $100.35 nominally (before calculating inflation) on an after-tax basis, and that in turn is worth about $98.34 after inflation.

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Some might argue that slowly losing money in this manner is not a safe investment after all. But what are the alternatives? Are there investments that are as safe but offer better returns? Unfortunately, the answer is no, but you may find that there are higher-yielding investments that come with only minimal extra risk, such as GICs and high-interest savings accounts from large financial institutions covered by deposit insurance (CDIC).

For example, ING Direct Canada currently offers an interest rate of 1.50 per cent on its investment savings account, which has no minimum balance requirements and no fees. As a CDIC member, ING can insure up to $100,000 per account if the bank collapses.

I personally have a savings account with ING Direct Canada and I'm not worried in the slightest about the extra risk over a Canada Savings Bond, but technically, the risk is there. ING doesn't have the power to print money or increase taxes to cover interest and repay principal to me, whereas the government does. But again, the chance of having the bank fail feels about as likely as me winning the lottery two weeks in a row.

Many banks are competing on interest rates for their savings accounts and GICs, but you're not going to see a 5-per-cent return on an "safe" investment today. The capital markets work on the age-old principle that risk and return are closely related. Overall, you might squeeze out an extra 0.25-per-cent return from a GIC without adding of a lot of risk compared to a savings bond. Beyond that, however, even a small increase in return is likely to come with incrementally higher risk.

So the next time you see someone advertising a "safe" alternative to a GIC (or similar) with a higher return, remember to ask why. You may find that you are comfortable with the additional risk, and that's fine.

The potential of higher returns comes with additional risk. If it didn't, everyone would just arbitrarily select the higher returning investments without a second thought, wouldn't they?

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About the Author
Personal Finance columnist

Preet Banerjee is a consultant to the financial services industry. You can follow him on twitter at  @PreetBanerjee. You can find his conflict of interest disclosure on his website. More

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