Investors looking to achieve higher returns for incremental risk compared to other asset classes need look no further than bonds.
Outlook for term deposit rates
Many investors have been caught sitting on spare cash or surplus funds earning minimal income from other asset classes, such as term deposits.
Term deposit rates have been stuck at lows due to unconventional monetary policies, and while central banks are beginning the final stages of unwinding such policies, it remains to be seen how aggressive the Reserve Bank of Australia (RBA) intends to hike rates and when lift-off will begin.
The RBA is faced with contained inflation (currently at the midpoint of the target range) relative to global peers and has suggested possibly hiking rates later this year (while both the UK and US central banks- among others- have already begun rate rises).
While markets have six rate hikes priced in for 2022 (at time of writing), it’s uncertain if the RBA hikes this aggressively.
It’s also worth keeping in mind, that coming off such a low base (the cash rate is currently at 0.10%), it won’t be until further into the tightening cycle that term deposit rates will be competitive, with generally the two moving in lockstep. The chart below plots the implied yield curve that the Overnight Cash Rate Futures is pricing in, which shows the cash rate only getting to 2.80% in August 2023, and that’s with 11 rate hikes (which may not eventuate).
For modest incremental risk, bonds offer a known income and the repayment of capital back at maturity for a better return, making them an ideal investment for idle funds.
Furthermore, bonds offer key features over other asset classes including a predictable income stream, liquidity and the opportunity for capital gains.
SMSFs asset allocations
While term deposit rates have somewhat improved since 2020 when we last discussed the topic, currently at around 0.85% on average for a 1-year major bank deposit versus 0.40% back then, it remains unsustainably low.
SMSF trustees have remained holding the relative safety of cash, with the ATO Super Statistics showing the allocation of SMFSs to cash and TDs has only marginally declined, despite rates remaining anaemic. The allocation to cash and term deposits has shrunk to around 18% from 21% since March 2020, while over the same period the allocation to bonds has been persistently subdued.
With term deposit rates remaining unsustainably low over this period (and earlier), it would seem reasonable to expect a rotation into bonds, which offer more attractive returns for modest incremental risk.
Looking at our sample bond portfolios, the Conservative portfolio (here) (all AUD and investment grade, the lowest risk offering), it currently offers an indicative yield of 4.60%. This bond portfolio returns approximately 4x the term deposit rate. The relative value of investment grade bonds has remained manifold since 2020, and yet the allocation to debt securities by SMSF trustees has remained constant at 1.40% of portfolios.
This points to a slow shift of assets away from cash over the period, but not to bonds, which are the next lowest risk asset on the spectrum- as shown in the below chart. This seems counterintuitive.
Asset class performance
On average the bond market in Australia (which is mainly investment grade and investment grade corporate issuance) has returned approximately 1.98% per annum more than cash, as the below chart illustrates.
This is the extra return you get paid for taking the credit risk (the risk you don’t get paid your interest on the due date and don’t get your capital back at maturity) of the corporate issuer compared to a term deposit in a bank.
The returns shown in the chart are generated from investing $100 on January 1, 1990 to March 30, 2022. Over the period, bonds have returned 8.78% per annum while the interbank lending rate (where all term deposits are priced off) has returned 3.77% per annum.
This excess return generated by holding bonds has been over 5.00% since 2019, and over 4.00% since 2016, demonstrating the foregone returns that would significantly impact the overall portfolio returns.
While term deposits remain at sustained lows, bond yields have pushed higher as the market prices in the upcoming tightening cycle. The 5-year Australian Government bond yield has spiked to 1.80% since late last year in anticipation of rate hikes, and even if these hikes do not eventuate, that higher rate is locked in at time of investing on fixed coupon bonds.
The relative value of investment grade bonds over term deposits (acknowledging bonds are inherently riskier and are not a direct equivalent but add only small incremental risk) is an attractive offering.
Key benefits of bonds
While other asset classes, such as term deposits, pay interest only at maturity or usually yearly when the term exceeds 12-months, bonds offer a more frequent cashflow. To achieve a more frequent interest payment on term deposits the interest is earned at a reduced rate to compensate, reflecting the lower credit risk.
The interest on bonds is paid either semi-annually, quarterly, or monthly, depending on the type of bond. This provides a known, regular income stream for investors.
Bonds can be bought and sold relatively easy, and prior to the maturity date, giving investors access to their funds. Bonds are generally a liquid investment depending on market conditions and the type of bond.
Term deposits require investors to forgo access to funds for a pre-determined period or are faced with break fees or penalty interest. This isn’t the case for bonds, where only a small margin between buyers and sellers is charged to trade.
Bonds trade in the secondary market, where their prices can fluctuate as a result of credit and market conditions. As such they have the capacity to increase (or decrease) in capital value. Term deposits don’t offer the opportunity for capital gain, while also locking in a known income.
Bonds can trade at a discount (below the price they were issued), or at a premium (above the price they were issued). Purchasing a bond at a discount means an investor can expect a capital gain if held to maturity, where they will receive the issue or par value (usually $100).
Bonds purchased at a premium can still make a capital gain if market conditions allow and if sold prior to maturity (where $100 is repaid).
Now is the time to take the step into the next obvious asset along the risk curve, increase or maintain your income and add bonds to your portfolio.