Term Deposits versus Bond Funds
Currently, with large sums of money invested in term deposits post the Global Financial Crisis (GFC), the question needs to be raised, “are term deposits where an investor’s ‘defensive’ assets should be invested?”
This paper outlines the pros and cons of term deposits and bond funds given the increased usage of these products post the GFC. The purpose of this paper is not to conclusively state which is better, rather to explain the differences and outline reasons why and circumstances when it may be beneficial to invest in either a term deposit or a bond fund.
Term Deposits
Term deposits offer investors a set rate of return, over a given term to maturity. This provides the investor with a known investment outcome (certainty) with minimal chance of default (assuming investments are made with institutions supported by strong credit ratings). Investors can select their desired term to maturity, usually up to 5 years, with interest paid monthly, quarterly, annually or at maturity.
Term deposits post the GFC have been an attractive investment given banks are offering significantly higher rates due to their desire to attract further retail funding. Many major banks are currently offering interest rates of 5.5% - 6% per annum for a 1 year term for $100,000 deposits. This rate increases to around 6.25% per annum for 5 years.
Given the deposits are still Government guaranteed until October this year, the risk of any capital loss would appear extremely low prior to October. Post October, given the strength of Australian banks, the chance of a major Australian bank defaulting in the near term post the guarantee would still appear very low. An interest rate of 6.25% per annum with minimal risk is indeed an attractive investment opportunity, or is it?
Reasons to use a term deposit
- Set rate of return.
- Set maturity date.
- Set value, no variable unit price.
- Choice of regular interest payments, interest at maturity or annually.
- If the set rate of return is equal to or greater than a client needs, use it, don’t take unnecessary risk.
Reasons not to use a term deposit
- Set maturity date makes the investment illiquid. Note most financial institutions will allow you to break term deposits, but the fees / penalties or foregone interest may make this an unattractive proposition.
- As opposed to a bond fund, the lack of duration* means that term deposits do not provide any upside in a poor economic environment with declining interest rates. Note that when interest rates are declining, equity markets are usually also declining or not performing well.
- If inflation increases, the return from a term deposit can be quickly eroded. That is, a term deposit that is paying a return of 6.5% per annum when inflation is 3% provides a real return of 3.5% per annum before tax. If inflation was to increase to say 5% per annum, this real return is more than halved to 1.5%, which after tax, if you are a tax paying investor, is highly likely to be effectively a negative return.
Note that NAB now offers a term deposit with the option of being inflation linked. This product is called a NAB Inflation Deposit. It offers investors interest linked to inflation with the option of also linking the principal amount to inflation.
* “Duration” in this context is a term referring to a bond price’s sensitivity to interest rate changes.
Bond Funds
For the purpose of this paper a bond fund is defined as one which predominantly invests in Government bonds, semi-government bonds and credit securities.
During the GFC, contrary to consensus opinion, not all investments were highly correlated and not all investments declined in value. Funds that were predominantly invested in Government Bonds, particularly longer duration bonds, performed extremely well. An example of this was the Vanguard International Fixed Interest Index Fund (Hedged) which returned 12.2% for the year to December 2008. Compare this to the -38.9% return over the same period from the S&P/ASX 300 Total Return Index and you can clearly see the defensive nature of a bond fund. Over this period, the correlation between the S&P/ASX 300 and the Barclays Capital Global Aggregate Index (Hedged) was around 0.1. This result means the returns were basically uncorrelated and thus bonds provided significant portfolio diversification. The chart below also shows the defensive nature of a bond fund, during some of the worst months of the GFC (September to November 2008). The Vanguard International Fixed Interest Index Fund (Hedged) returned 4.1% over these three months, compared to the S&P/ASX 300 Total Return Index which returned -26.5%.
Vanguard International Fixed Interest Index Fund (Hedged)
Value of $100 invested in Wholesale-fixed Income - Global - Government / Sovereign from Nov 2007 to Dec 2010
(before tax and fees)
Data Source: Morningstar and lipper. A Thompson Reuters Company
One important point to note is that the longer the duration of a bond or bond fund, the greater the impact of an interest rate change, both on the positive and negative sides. This means that 30-Year U.S. Treasuries may be a great investment in a declining interest rate environment, but they may well be one of the worst investments in a rising interest rate environment.
Reasons to use a bond fund
- Liquidity. Bond funds that invest predominantly in Government bonds and investment-grade credit are unitised and provide daily liquidity.
- Bond funds are defensive in nature. As opposed to term deposits, the duration element of a bond fund usually provides upside in a poor economic environment with declining interest rates. Note that when interest rates are declining, equity markets are usually also declining or not performing well. This makes a bond fund a true diversifier to a portfolio which may be dominated by equities.
- Given that a bond fund is a collection of bonds which pay income (coupon payments), bond funds provide regular income. Whilst the level of income can vary, it is unlikely that a bond fund will miss a distribution and therefore some degree of regular income can be relied upon.
Reasons not to use a bond fund
- Due to the duration element, bond funds generally lose value in good economic times with rising interest rates. Note that when interest rates are increasing, equity markets are usually performing reasonably well. This means that bond funds may not always produce positive returns.
- Unless a bond fund holds inflation-linked bonds, inflation can also be a major negative for a bond fund (as is the case with a term deposit). A bond fund, whose weighted average income is say 6% per annum, can also have this return very quickly eroded by inflation.
In summary, which option you choose is ultimately up to you, based on your needs and goals. The aim of this paper is to raise awareness of issues that need to be considered. While it is often assumed that a term deposit is a safe and suitable investment option, term deposits do have features and return characteristics that make them clearly different from bond funds and these differences should be understood as term deposits will not automatically meet investment needs over the long term. Please contact me if you would like to discuss these investments further.
The information contained in this publication is current as at 15 August 2011 and is prepared by ThreeSixty, a division of GWM Adviser Services Limited ABN 96 002 071749, registered office 105-153 Miller Street North Sydney NSW 2060. This company is a member of the National group of companies.
Any advice in this publication has been prepared without taking account of your objectives, financial situation or needs. Because of this you should, before acting on any advice, consider whether it is appropriate to your objectives, financial situation and needs.
Past performance is not a reliable indicator of future performance.
Before acquiring a financial product, you should obtain a Product Disclosure Statement (PDS) relating to that product and consider the contents of the PDS before making a decision about whether to acquire the product.