Money in the bank: Fixed Interest vs Term Deposits

Written by Kate McCallum, Multiforte

Before evaluating the benefits and risks of fixed interest investments versus term deposits, it's helpful to re-cap on what each one is.

What is fixed interest? What is a term deposit?

Fixed interest, also known as bonds, operate like an IOU - where you lend your money to the issuer of the bond, who is often a government entity, a bank or company.  There is a set time for repayment of your loan and an agreed rate of interest paid to you over that term. Your initial capital is then paid back to you in full at the end of the investment term. Most people access fixed interest securities through a diversified managed fund.

A term deposit also has an agreed fixed term. However, this is a deposit at a bank (or other deposit-taking institution) and is one-to-one transaction that you negotiate with the bank - such as term to maturity, frequency of interest payments, and interest rates.

Like bonds, term deposits pay a fixed rate of interest. Unlike bonds, however, they must be held to maturity - there is no secondary market where you can buy and sell to other investors. This makes them relatively illiquid - of course you can break a term deposit before maturity, but you will pay penalties if you do.

With a term deposit, you receive your capital back at the end of the term. However while there is minimal risk of capital loss, there is also no potential for capital growth.

What are the benefits?

With fixed interest, there are five key benefits:

1. Capital preservation - by definition, principal is to be repaid to investors upon maturity of the investment. Combine this with the strong credit-worthiness of many fixed interest issuers, and you have an effective form of capital preservation.
2. Liquidity - which simply means that you can access your cash quickly and easily if you need it.
3. Enhanced returns over cash - fixed interest will usually generate a return higher than you would get in an at-call bank account. This is because you are taking on more term and credit risk for the possibility of getting a premium over cash.
4. Reliable income stream - particularly where you have a broad array of bonds (for example, through a fixed interest fund).
5. A cushion against market volatility - because fixed interest is less volatile than shares, and they are negatively correlated, they provide a stabilising effect in a portfolio. Fixed interest securities also exhibit a flight to quality characteristic in declining share markets, since yields tend to fall, which then increases the value of existing fixed interest securities. Just by adding a little bit of fixed interest to a balanced portfolio can provide a cushion through the ups and downs without making a significant dent in returns.
    

Term deposits offer 3 key benefits:

1. Capital preservation - a term deposit with an Australian bank or other authorised deposit-taking institution is a safe bet. and you have the comfort of a federal government guarantee on deposits of up to $250,000.
2. Certain income - a term deposit provides you with the certainty of a fixed rate of interest which you know upfront when you deposit your funds.
3. Enhanced returns over cash - currently, term deposits look attractive. According to the Reserve Bank of Australia, the 'spread' or premium offered by term deposit rates over the cash rate set by the RBA has increased since the financial crisis. This is because banks' alternative source of funding - in the wholesale money markets - has become more expensive. As a result, they are increasingly relying on deposits from retail investors. And the resulting competition has driven up retail term rates relative to the cash rate.

So, what are the risks? 

There are two key risks when investing in bonds: 

1. Term risk - which is the risk involved in lending out your money for an extended period. Generally - although not always - the longer the term, the better the interest rate.
2. Credit risk - which is he risk of the borrower defaulting on the loan or at least the risk of default increasing. Generally - although not always (as we saw in the years leading up to the GFC) - the higher this risk, the higher the expected return. 

It's also important to touch on the recent speculation about bond prices falling. Currently bond yields are very low, and it is expected that they will go up when the global economy recovers. If bond yields go up, then the price of bonds goes down, and a recent investor in the asset class will be looking at a loss - but this is only if they were to sell. If investors hold the bond to maturity, then no loss will be incurred and payments will be made and money returned when the bond matures.

Turning back to term deposits, while they are very safe, there are 4 risks to consider:

1. Liquidity risk - you access your money whenever you like as it is locked away for a period or months or years. You can always break the deal, of course, but fees and charges can be onerous.
2. End of the government guarantee - this has recently been reduced (as of February 2012) and can be removed at any time. This is not to suggest the banks are at risk of default. But the proposed removal of an explicit, if not an implicit, safety net does diminish one perceived attraction of term deposits.
3. Loss of control - unless you explicitly intervene, term deposits can automatically roll over when they mature to much less favourable rates. Then you can find yourself locked in for an extended period at rates lower than are available elsewhere. To this point, the Australian Securities and Investments Commission in 2010 released a major review of term deposits that found that authorised deposit-taking institutions actively advertised higher interest rates on one or two term deposit terms while maintaining lower interest rates for all other deposit terms. On average, these lower rates were 42 per cent below the advertised offers. ASIC also found a weighted average of 47 percent of term deposit funds that rolled over for the first time automatically defaulted to lower rates.
4. Interest rate rollover risk - term deposit rates in Australia are at historically high levels relative to the existing rates on offer in the money market. While this is good for depositors right now, the risk is that this is a very unusual occurrence and may not be maintained. We have already seen cash rates decline in late 2011. This raises the prospect of investors of coming out of a term deposit and having to roll over at less favourable terms, with all the uncertainty that this generates. 
    

Fixed interest and term deposits both have a role to play

We believe both term deposits and fixed interest funds can have a role to play in your portfolio, depending on what you are seeking to achieve.

Term deposits are safe and are currently offering attractive interest rates over certain terms - mostly thanks to the banks' preparedness to pay attractive rate to secure funding. If you have money that you can set aside for a given timeframe, a term deposit can be a good option.

Where you need greater liquidity, and are looking for enhanced returns without the risk of rolling over to a lower rate, a fixed interest fund should be considered.  Many will have a more term risk and a little more credit risk than term deposits in order to provide a return premium over the standard cash rate. This is usually achieved with consideration for capital preservation.

Importantly, fixed interest funds are more diversified than a simple term deposit held with a single bank. They invest in a broad range of high quality fixed interest securities, including the bonds of governments, major banks, international organisations like the World Bank and top-rated corporate borrowers. And because International Fixed Interest funds are usually fully currency hedged, the yield will be equal or better than the prevailing Australian cash rate - so even though the headline rate may appear low, the income can still be attractive. Global diversification with fixed interest securities also means that you are not wholly dependent on what happens to Australian interest rates.

What should you do?

Term deposits are an attractive option for assets you wish to preserve and gain certain income from. They are relatively safe and, at least at the moment, offer attractive terms. 

We believe it is important to complement these investments with a high quality fixed interest strategy, with the potential for greater diversification and return upside.