According to the old adage, there is no such thing as a free lunch. Although term deposits secure capital, it means giving up the potential for capital benefit as the Australian economy cools.
By fixing a rate of interest, an investor effectively takes a pessimistic view on the economy with an expectation that interest rates could decline – why else does one secure an explicit interest rate?
But term deposits lock up an investment in a structure where none of the return benefits of falling rates can be exploited.
Investors have, in effect, lost money because of this “duration” risk. Losses haven’t been realised because term deposits are not valued to market rates on a regular basis. In fact, capital is locked-up with the perception of complete capital stability, and only early-break fees will grant flexibility to reallocate accordingly.
All about lifestyle
Arguably, the biggest challenge facing investors today are the lifestyle implications following the capital losses of the global financial crisis. For retirees, diminishing returns and contracting income, for example, from term deposits inflict immediate challenges to meeting one’s lifestyle expectations.
Unsurprisingly, investors who have been invested in term deposits yielding 7 per cent three years ago are now faced with a reinvestment option yielding closer to only 4 per cent today.
The income cliff on a $100,000-term deposit balance is about $10,000 for this period; hence, retirees recovering from capital erosion during the financial crisis need more assurance when it comes to income. It is therefore essential to rethink the methods of income generation.
Understanding income
Investors are growing concerned about the uncertainty in today’s global economy and what that might mean for rates of return on all asset classes. At the same time, when investing for income, there is concern about the risks within some over-indebted sovereign-bond issuers. Yet it’s important to understand how bonds generate income.
When you combine the two components of a bond’s return – yield and capital appreciation – you get its total return. As cash rates have been reduced to stimulate the Australian economy, bonds have appreciated in value.
Bonds are primarily income-producing securities, but, in fact, they can offer very attractive capital appreciation and have done over the past five years as the general level of interest rates has fallen in response to slowing global economies.
Fixed-income securities feature contractually obligated and predetermined coupon payments or income payments. On a set schedule, be that quarterly, twice a year or annually, income is paid to the bondholder. Equities also pay income, but these dividends tend to oscillate and, unlike bond coupons, which are contractual, dividends of equities and many hybrid securities are issued at the discretion of company management. This means that in a downturn, the income can be cut or even eliminated altogether.
Get to grips with risk
For investors who are relying on a generous, consistent income stream to allow for improved lifestyle planning, mitigating risk is essential. The global bond market is a colossal $100-trillion ‘supermarket’, with many different aisles and a constant inventory of defence and opportunity.
Term deposits have played a meaningful role in a period of grand uncertainty, but investors need to contemplate the risks at a time when deposit rates are falling. Break fees, reinvestment risk and missed market opportunities may be some of the challenges that investors need to consider.
For assurance, a diversified fixed income strategy can better enable planning to meet lifestyle needs. Short of default, high quality bonds will return capital at maturity while providing a steady stream of income along the journey.
John Valtwies is a portfolio specialist at PIMCO Australia.
