What NOT TO DO When Interest On Term Deposits Drops

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Whilst the rest of the world has been starved of yield (income) for the past decade or so, Australian investors have been relatively immune to this issue given higher cash rates (up until recently), higher yields on government bonds, and relatively high rates on offer from term deposits.

Even the dividend yield on Australian equities (shares) has remained attractive through that time!

So with the RBA cash rate heading lower, with banks slashing the interest rates on term deposits, with the 10 year government bond yield now at ~1.27%, and with Australian equity prices pushing higher (hence lower dividend yields), what’s an income seeking investor to do?

Rather than focusing on what each investor should do, which is rather specific to their individual circumstances and needs to be discussed with their adviser, the following focuses on what investors shouldn’t do – that is, CHASE YIELD.

Chasing yield generally results in little regard for the additional risk being taken and usually comes at a time when risks are less obvious or more depressed than they would normally be. That current environment that we are in isn’t permanent, and the greatest risk in any portfolio is an unknown risk or a risk that is not well understood. Chasing yield without full regard for the additional risk being taken is more than likely going to result in temporary or permanent loss of capital.

Chasing yield generally leads investors to cash in their term deposits and/or defensive bond funds in order to purchase corporate debt, mortgages, loans, high yield debt, hybrids, and even equities. There’s nothing specifically wrong with those asset classes mentioned, so long as you understand the increasing risk being taken as you move further and further away from something secure like a term deposit. Unlike interest on term deposits, these other investment classes can be promoted and employed by much smaller institutions with fewer safety nets if things don’t pan out so well.

Low Interest Rates Are An Opportunity For Spruikers

In periods like these, where cash rates and yields are low, we undoubtedly see the proliferation of products “promising” or “guaranteeing” 5% returns with “capital guaranteed”, where the product is likened to at-call or term deposits. The marketing behind these products uses emotive, persuasive, and comforting language in order to entice investors to invest. Sometimes these products even use high profile people to endorse their products…….that should always ring alarm bells!!

The problem with the marketing is that it can be misleading or false. While it’s becoming increasingly difficult for spruikers to promote their shoddy products, where there is a will there is a way and these 2nd and 3rd rate alternatives will find a way!

There is no such thing as a “guaranteed return” or a “capital guarantee” – they just don’t exist. A 5% income return is actually higher than the dividend yield on the average Australian stock – as such the risk of such return is effectively the same or higher than that for equities.

Many of these products take investor money and invest it in a range of activities including property development (and even speculation), private equity, loans to directors, mortgages, etc. The risk of temporary and/or permanent capital loss is high. These investments generally aren’t liquid, so the product will promise daily liquidity (access to your funds) only by virtue of the hope that other investors keep investing into the product so they can use their investment to fund your withdrawal. Additionally, the actual underlying use of the funds generally earns a much higher return that the 5% being promised – ie. the end investor is wearing all the risk for a 5% return, whilst product provider wears no risk and generates a return anywhere from 2-4 times that amount!

Don’t be tempted by high returns on what is marketed as a “defensive” investment. If returns are high, the requisite risk is high. There is no free lunch (outside of diversification). While it is not unusual for defensive investments to sometimes provide a strong return, their main purpose is to provide stability and minimise the risk of losing money. When riskier assets aren’t doing so well, the idea is that defensive assets are holding the fort.

A well balanced defensive allocation in any portfolio is very important – equally important is thoroughly understand the risks being taken as you seek higher returns.

The moral of the story is, when it becomes harder to get a return on your investment or cash, it also becomes riskier to try something new.

In summary, while a guaranteed 5% interest rate doesn’t sound very risky, in this environment it gives off a funny smell.

If you’re looking for a way to generate a higher return, that’s in line with how much risk you would naturally like to take, please reach out to your financial adviser to have a chat.

If you’d like to learn more about the foundations of investing, visit the investment section of our blog or read up on our investment philosophy.

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