What are the alternatives to Term Deposits?

What are the alternatives to Term Deposits?

With the returns on term deposits and other cash like assets in Australia falling, many investors are wondering what alternatives may be available to them.

A recent article in the Sydney Morning Herald (SMH) offered some suggestions.  We were somewhat mystified at what they had to say.

We have long contended that the financial media focuses on an agenda of ‘fear and greed’ to sell newspapers or advertising space.  Their commercial motivations are not aligned with their readers interests, as Steve Forbes, publisher of Forbes Magazine, once said:

“You make more money selling advice than following it. It’s one of the things we count on in the magazine business – along with the short memory of our readers”1 .

Worryingly, around 50% of people with a self-managed super fund rely on the financial media to make investment decisions2.

Of the seven alternatives to term deposits mentioned in the SMH article, two of them were dubious whilst three posed fundamentally different risk characteristics for investors.  We discuss the alternatives listed in the article below.

Cash at call
The SMH article stated cash at call has ‘absolutely no risk’ – we assure you that no such investment product exists.  Putting your money in a bank exposes you to the underlying credit risks of that particular financial institution.  And whilst the government guarantee for balances of up to $250,000 remains in place (but is unlikely to continue indefinitely), we understand many investors have cash holdings far greater than $250,000 with various banks.

Some cash accounts offer attractive bonus rates, but it’s often only for four or six months, after which the rate falls significantly.  We believe minimising your cash holdings and investing surplus cash into higher yielding, high quality bond funds or term deposits will always be the most prudent approach for investors.

Corporate bonds
Corporate bonds are a solid investment – we recommend them to clients.  However, there are some factors that need to be considered.

Typically to buy a corporate bond, you need to invest a minimum of $100,000.  This gives you a holding in one issuing entity.  Such an arrangement fails our test of diversification.

You also need to be aware of the financial wellbeing of the company issuing the bond.  We focus on the more secure companies – but they represent a small percentage of the overall corporate bond market.  For example, one Westpac bond is currently paying 6.02% pa, whilst a Caltex Australia bond is paying 8.05% pa.  Many investors would simply buy the Caltex bond for the higher yield without considering the risk they are exposed to.  Westpac is rated AA, Caltex is rated BBB+.

Just before the GFC, many investors were unhappy with the yields that bonds issued by low risk companies were paying, so they moved into higher risk bonds to get higher returns.  When the GFC hit, many of these high risk bond portfolios incurred losses of 40% or more.  In comparison, term deposits in low risk banks experienced no capital loss.

A focus on income without any consideration of capital risk is a trap many investors fall into.

We now discuss the three alternatives in the SMH article that simply aren’t comparable to term deposits and expose investors to a completely different set of risks.

Equity income funds & Enhanced income funds
The marketing names given to these funds often hide their true risk.  These funds invest in shares – but target shares with higher dividend yields to generate more income.  When you consider that term deposits have no capital volatility, to call equity income funds an alternative to term deposits is preposterous.  The graph below provides a reminder of what happened to the capital value of term deposits compared to Australian shares in 2008:

 What are alternatives to Term Deposits (1)

Source: Returns Program. ASX 500 Price Index used as proxy for Australian shares

The equity income fund was worth around 43% less than the term deposit by the end of December.

Some enhanced equity income funds use derivatives to allow investors to cap future capital growth for more income now. This added complexity provides investors with higher costs and less transparency and, like equity income funds, is not a real alternative to the simplicity of term deposits.

Real estate trusts
We believe that real estate investment trusts (REITS) play an important role in investment portfolios, but not as an alternative to term deposits. REITs are a distinct asset class and have unique risk and return characteristics. Even the SMH article admits ‘of course, it all fell apart [for REITs] in the GFC’!

The following graph proves just that – the outcome was worse than for Australian shares with capital values down 55% during the course of 2008:

 

Source: Returns Program. ASX 300 Property Accumulation Index used as proxy for Australian shares

Again, with so much capital volatility risk compared to term deposits, to consider REITs as an alternative is implausible.

We believe that term deposits are a good solution for many investors, but believe that better alternatives are available. That’s why we generally don’t recommend term deposits for clients. The benefits of our alternative approach include:

  • Liquidity – access your funds within 5 business days rather than wait until your term deposit mature
  • Less risk – invest in a pool of AAA and AA rated bonds from around the world rather than putting all your funds with one financial institution with a probable AA credit rating at best
  • Higher historic returns – the graph below shows the historic performance of our approach compared to one year and special rate term deposits over various time periods:

 What are the alternatives to Term Deposits (2)

Source: Returns Program and Reserve Bank of Australia to 31 December 2012. For periods greater than 12 months, returns are annualised

We believe that an approach that provides less risk, easy access to your funds and higher historic returns of around 2% pa is a true alternative to term deposits.

So our advice is don’t listen to the financial media – their agenda is sales, not education. If you haven’t yet read the book ‘The Investment Answer’, we recommend you do so to understand the fundamental principles of investing. If you would like a copy, please contact us.

 

1 – Steve Forbes, presentation at The Anderson School, University of California, Los Angeles, 15 April 2003
2 – ‘Intimate with self-managed superannuation’, Russell Investments, 2011

 

Author: Rick Walker

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Note: This material is provided for information only. No account has been taken of the objectives, financial situation or needs of any particular person or entity. Accordingly, to the extent that this material may constitute general financial product advice, investors should, before acting on the advice, consider the appropriateness of the advice, having regard to the investor’s objectives, financial situation and needs. This is not an offer or recommendation to buy or sell securities or other financial products, nor a solicitation for deposits or other business, whether directly or indirectly.