This article was published in the Australian on Saturday and discusses the modest returns from term deposits in the current low rate environment. While the RBA did not cut rates last week, many economists are still of the view that rates will be lower this year and into the future so, where does cash fit in an investment portfolio?
Too often regulators seem to forget that while a rate cut is positive for those with a mortgage, it sends retirees back to their cashflows to try and work out how they can live off a declining income stream.
Experts suggest investors should keep two years' cashflow in deposits as a precaution against a major market dislocation. Depending on your lifestyle, this could be upward of $150,000.
Although interest income is low, in terms of the lowest-risk investments available to retail investors, deposits still come out on top. That’s why, according to the tax office, self-managed superannuation funds allocate 29 per cent of their portfolio to deposits.
Deposits have a very high degree of capital certainty; capital is returned at maturity. If the funds are held in one of the 167 authorised deposit taking institutions (ADIs) and overseen by the regulator, APRA, then the first $250,000 held in each ADI qualifies for the government guarantee.
The only word of caution here is that subsidiaries of a bank are counted as being the same entity. For example Westpac, St George and Bank of Melbourne are all considered the same entity because St George and Bank of Melbourne are brand names belonging to Westpac.
Income on deposits is also known upfront and is paid at maturity, or more frequently if needed, although the interest rate will be lower to allow for compounding. Deposits from 90 days to a year currently pay in the range of 2.2 per cent to 2.9 percent. If you have $250,000 to invest, you can earn 3 per cent for a year. Beyond a year and out to five years, the rates on offer rise less than 1 percent. A good five year term deposit rate is 3.45 per cent from Rabobank.
Deposit investors, without even realising it, take a view on interest rates. Those that think interest rates will be lower for longer may be happy with the extra return on offer to extend the term out to five years. But the five year term hasn’t been popular. A good option at the moment is 3.20 per cent from ING Direct for two years.
Is there any hope that deposit rates will rise?
The way professional investors assess the market’s future expectation of interest rates is to look at the swap curve. Basically this is the rate at which banks are indifferent between investing in fixed or floating rate investments. The curve changes daily and is now relatively flat. The one year quarterly swap rate is 2.01 per cent (implying the market expects an interest rate cut in the next year), moving to 2.34 percent at five years and 2.73 per cent over 10 years.
The swap curve tells us the outlook for better deposit rates is bleak. If you deduct inflation from your interest and also pay tax, your return is so low you might as well put it under the mattress.
The other main asset classes of property and shares should provide higher returns but are higher risk as there is no guarantee to pay income (rent and dividends) and the return of capital is dependent on the sale of the asset.
Bonds have similar characteristics to deposits. They also return capital at maturity and pay a defined income that is stated at the outset of the investment, although they are generally slightly higher risk.
No matter what your portfolio allocation, I would always suggest you have an allocation to deposits.
It is important to note that the term deposit rates included in this article were accurate at the time of writing, 8 April 2015, and are subject to change. Please contact your FIIG representative for further information or call 1800 01 01 81.