Many investors favour deposits in stressed markets but Australia’s largest institutions have other ideas
The developing North Korean crisis and war of words between its leader and the president of the United States continues to escalate. Yesterday, White House press secretary Sarah Huckabee Sanders called North Korea’s claim that the United States has declared war on the rogue regime “absurd.”
None of us want to think that a war is possible, but what if?
In times of severe market dislocation, investors look to shift funds from growth assets into those that will preserve capital. Investors sell shares and higher risk assets in favour of those that at least maintain value. Commonly, deposits increase, assuming investors have confidence in the banks, as does the highest quality government bonds, including supra-national bonds and some very highly rated corporate bonds. Gold is another favoured play.
Investors may completely sell out of certain asset classes but more often it’s a matter of recalibrating allocations. Deciding the capital value you want to protect, determining the taxation impact of selling down - particularly for long held assets that might be sitting on significant capital gains – then deciding the protection that’s right for you.
We’ve already seen some very well known fund managers moving to higher ground, holding 40 per cent cash, waiting to pounce on cheap assets when and if the markets tank.
The game is changing - investors’ main motivation shifts to keeping nest eggs intact. Low returns on low risk assets become more palatable, the alternative is the potential for a big drop in capital value.
Australian taxation office figures show that SMSFs have approximately 26 per cent of their portfolios allocated to cash. Deposits are a very low risk investment and funds held in approved deposit taking institutions of up to $250,000 per entity, per institution are covered by the government guarantee. At call accounts offer miniscule returns in exchange for access to funds and to get anything almost decent, you need to invest in a term deposit.
The downside is that you lock away funds for set periods of up to five years to get better returns.
Locking funds away makes sense to preserve capital but not if you want to take advantage of a correction. Nevertheless, deposits are the most common defensive investment in Australia for personal investors.
Institutional investors will also hold cash but at much lower levels. Most invest in government bonds, with Australian Commonwealth government (ACG) being the most widely held and the lowest risk but will also include state and territory bonds.
A good major bank term deposit one year rate might be 2.4 per cent per annum while an ACG three year bond offers 2.04 per cent per annum.
Both the term deposit and the ACG are government guaranteed. The interest rate differential makes it look like an easy choice – the term deposit pays higher income, so why consider government bonds? The fact that institutional investors are buying government bonds highlights the need to delve further.
One of the big advantages of ACG bonds is that they are very liquid. Millions are traded daily and there are many global investors. Sellers can access capital quickly, so take advantage of a market correction with little effort or loss of income, unlike term deposits. Typically, all bonds trade on a trade plus two day settlement.
Most government bonds are fixed rate so the interest rate stated at first issue must be paid over the life of the bond, no matter what happens to interest rates. So, some older government bonds available in the secondary market, offer great cashflows for a ‘zero risk’ investment. Take the ACG April 2027, showing a yield to maturity of 2.73 per cent, but paying rather good income of 4.07 per cent per annum. Investors take the income, wait for the correction or a point where interest rates start to rise, or the risk subdues, then sell. The higher income will help offset price movements of the bonds if they don’t perform as expected.
Another benefit for institutions is that they can trade ACG in size, where they may be limitations in term deposits.
A severe correction will see ACG bonds outperform as investors employ a ‘flight to quality’ trade. ACG prices rise steeply and investors that already hold an allocation benefit. They can sell the bonds at a profit, offsetting the poor performance of other higher risk assets. Static deposits don’t offer that sort of protection!
What can negatively affect an ACG?
The greatest risk to your investment is rising interest rates, or an expectation that interest rates will rise. In either case, the fixed rate bond prices will fall. The beauty of any bond investment though, is that if the entity that issued the bond survives, investors get the face value of the bond back at maturity, preserving capital.
If Australia suffers a credit rating downgrade from Standard and Poor’s or Moody’s, theoretically the price to issue new bonds would increase and existing bond prices would be expected to fall.
Institutional investors judge that liquidity and the chance to outperform and earn higher than expected returns - as well as offset potential losses in other investments give government bonds the edge over deposits.
Retail and sophisticated investors can also employ the strategy and invest in ACG bonds. They are available through bond brokers and there is a range available via the ASX.