Term Deposits are Dead, long live Term Deposits
Term deposit rates have been low in recent times. At the time of writing, the highest advertised 12-month rate I could find was 3.70%pa. Interestingly, I found a 9-month rate of 3.85%pa and a 6-month rate for 3.70%pa. So, the question must be asked why would you invest in 12 months’ vs 9 months vs 6 months. We will answer that shortly. The highest rate I could find for 3 years was 4%.
I have heard people say, “why would you invest your money in a term deposit, you’d be better off with your money under your mattress?” I know they are only joking when they say that.
However, there is a very real risk that investing in term deposits will impact on your ability to maintain your lifestyle if you rely on the income and have all your money invested in cash. If you’ve been reading my previous blogs, that is not the only risk you face. Having all your funds invested in one company i.e. a bank, there is also the risk that a bank will default. The table below illustrates the levels of risk based on a bank’s credit rating.
So you have a concentrated risk, when your wealth is tied up in one asset class. Many of you will argue that it is still safer than investing in a portfolio of shares and bonds. You may be right. But it depends on how well your portfolio is diversified. A small portfolio concentrated in one asset class is obviously more of a risk than a large portfolio spread across many different assets like shares, property, bonds and spread around the globe.
As mentioned, you also have investment risk where your assets don’t perform well enough to maintain your lifestyle. After fees, inflation and tax your return means you must cut back your spending.
Term deposits are not typically managed by advisers so that means there is normally no fee for having that investment. Although, an adviser can manage them for you for a small fee. The advantage being they can switch banks for you to where ever the best return for your time frame is, based on risk. That means no additional paperwork each time you switch banks and your term investments are reported with your other investments making it easier for your accountant.
So, I guess many of you will be wondering what the real return is after you deduct inflation, tax and fees. Firstly, let’s look at the gross return of a current 3-year term deposit vs some expected portfolio returns. I must emphasise the expected return. This is the long-term return that we would expect based on historic modelling. The actual returns for the portfolios during 2016 were 6.72% for the 20/80, 9.12% for the 50/50 and 12.95% for the 98/2 portfolio. (The split represents Growth assets on the left including shares and property/income assets including fixed interest and bonds on the right) While the term deposit rate is 4%. I have chosen a 3-year term deposit rate as that is the recommended minimum timeframe for holding our most conservative portfolio.
So, from looking at this table you can see the returns in the portfolios are much stronger than in a term deposit. The conservative 20/80 portfolio performs 1.63 times better than the term deposit and the most aggressive portfolio 2.32 times better than the term deposit. Many of you will be thinking, yes but that is before fees. The performance is not that much better after you deduct those factors. On top of that, the risk is higher. Let’s deal with the performance after deductions first and the risk later. The real performance is illustrated in the graph below.
So how do the portfolios perform now once we deduct fees, inflation and taxes? Even better. The conservative 20/80 portfolio performs 1.66 times better than the term deposit vs 1.63 before deductions and the most aggressive 98/2 portfolio performs over 4 times better than the term deposit.
So, let’s address the risk questions. Firstly, because of the nature of portfolios they are more volatile than the performance of a term deposit. So, there is the risk that when you require your funds out the value may be less than when you put it in. That is why there is a recommended investment timeframe associated with each portfolio. You will also experience negative performance at some stage within a portfolio where as you won’t in a term deposit. A term deposit will deliver stable performance.
The other concern is that your money will disappear where as in a term deposit it won’t. Well I have already given you the probability of default rates for banks with different credit ratings. The chances of losing your money are low, but banks do default. It has happened in New Zealand and many banks across the globe.
Our portfolios invest in over 8000 securities across the globe. It would take the failure of capitalism to cause the portfolios to fail. With a term deposit, you are potentially invested in one bank that guess what, invests in capitalism. They lend your money to businesses, corporates and families that our portfolios invest in. They have already taken their fee out in the margin. They borrow off you at around 3% and lend it to others at around 5% or higher depending on their risk profile. These percentages are estimates only.
Think about the many finance companies and banks that collapsed during the global financial crisis in 2008. Our conservative 20/80 portfolio didn’t have a negative year in 2008, it returned 4.2%. Our most aggressive portfolio had a negative performance of -26%. The following year it came back with a positive return of 28.1%. Investors were rewarded for their patience and suffering!!
Term deposits do have a place in an investor’s portfolio. Currently, I would be using them to achieve short term goals, less than 3 years. In the future, there may be times when a longer timeframe is appropriate. The term chosen should reflect the timeframe you have for a goal to achieve. However, if that goal is a desired sustainable income I would question whether continually rolling term deposits is the most appropriate strategy. That may not be a short-term goal depending on your life expectancy.
Term deposits provide certainty of performance and the chances of default are low. Currently, I wouldn’t be going any longer than 6 months even if your goal time frame is longer. When it expires roll it onto the next most appropriate term within in your goal timeframe that adequately compensates you for risk and term. The banks are not currently providing the additional compensation for having your funds for longer. This is riskier for the investor. Yield curves are trending up so that indicates the market believes rates will be higher in the future. That means at the end of your six months you may be able to get a higher rate. However, the future is never that certain, just ask Hillary Clinton!!
Lastly, term deposits are like a comfort toy or blanket for some investors. The idea of having their money in anything else causes them sleepless nights. If you are one of those people you probably stopped reading earlier when you realised this was an intervention. However, we all needed an intervention at some point when we gave up our comforter. Maybe you kept reading and feel more prepared to look at a diversified portfolio. Don’t worry I won’t take it away if it means that much to you!!
Disclosure: The advice in this article is of a general nature and reflects my opinion. It should not be taken as personalised advice. Your goals, personal risk tolerance and capacity need to be taken into consideration before personalised advice should be discharged and implemented. Past performance is not a guarantee of future performance, we cannot control the markets. For personalised advice about your investment portfolio or if you have any questions or feedback please contact me on 021 414 755 or zn.oc1601282745.rets1601282745ibsi@1601282745ttam1601282745
- Posted by Isbister
- On February 15, 2017