Lower for longer: why term deposits are risky

Lower for longer

In times like the present, a focus on the income an investment provides is important. First, with interest rates set to remain low or fall further, bank deposit rates – already at their lowest in Australia since the 1950s – are likely to remain low or go lower.

For investors relying on bank interest, the decision by the Reserve Bank of Australia (RBA) to cut the official cash rate by 0.25% taking it to a record low of 1.5%, will shrink deposit rates even further.

Beyond day-to-day cash requirements, the key for investors currently in cash or term deposits is to work out what is most important to them: absolute certainty regarding the capital value of their investment or obtaining access to a higher, more stable income flow at the cost of volatility in the value of their investment. In this, there are several alternative investments to cash.

Looking for income: alternatives to term deposits

The chart below shows the yield on a range of Australian investments. Yields on global investments tend to be lower.

Source: Bloomberg, AMP Capital, as at 31 January 2016

All of these yields have fallen over the last few years as interest rates have fallen, but as can be seen several of the alternatives do offer much more attractive yields than term deposits.

• Australian 10-year bond yields are now around 2.5%. This will be the return an investor will get if they hold these bonds to maturity. They can generate a higher return if yields continue to fall, but they are already very low. Global bond yields are lower, averaging around 1%.

• After the house price boom of the past 20 years, the rental yield on capital city houses is just 2.8% and that on apartments is around 4.2%, and even lower after costs.

• Corporate debt is an option for those who want higher yields than term deposits but don’t want the volatility of shares. For Australian corporates, investment grade yields are around 6.5% or less and lower quality corporate yields are higher. Sub-investment grade corporate bond yields in the US are actually now yielding around 9% as worries partly about loans to energy companies have pushed them higher.

• Following the turmoil of the global financial crisis (GFC), Australian real estate investment trusts (A-REITs) have refocused on their core business of managing buildings, collecting rents and passing it on to their investors, with lower gearing. While their distribution yields have declined as rental growth has not kept up with total returns of 15% over the last five years, they are still reasonable at 4.8%.

• Unlisted commercial property also offer attractive yields, around 6% for a high-quality, well-diversified mix of buildings, but higher for smaller, lower quality property. And it doesn’t suffer from the overvaluation of residential property.

• Unlisted infrastructure offers yields of around 5%, underpinned by investments such as toll roads and utilities where demand is relatively stable.

• Australian shares also fare well in the yield stakes. The grossed-up dividend yield on Australian shares at around 6.9% is well above term deposit rates, meaning shares actually provide a higher income than bank deposits. In fact, the gap is now back to levels seen during the GFC.

Key issues for investors to consider

All of the alternatives come with a risk of volatility in the value of the underlying investment. In the case of shares, the key for an investor is to work out whether they want a stable value for their investment, in which case bank deposits win hands down, or a higher, more stable income flow, in which case Australian shares win hands down.

More broadly, in searching for a higher yield investors need to keep their eyes open. It’s critical to focus on opportunities that have a track record of delivering reliable earnings and distribution growth and are not based on significant leverage. In other words, make sure the yields are sustainable. On this front it might be reasonable to avoid relying on some Australian resources stocks where current dividends look unsustainable unless there is a rapid recovery in commodity prices.

Source: AMP Capital

Shane Oliver, Head of Investment Strategy and Economics and Chief Economist at AMP Capital, is responsible for AMP Capital's diversified investment funds. He also provides economic forecasts and analysis of key variables and issues affecting, or likely to affect, all asset markets.

Paul Clitheroe, Executive Director at ipac, is an Australian financial analyst, financial advisor, publisher and television presenter.

Important note: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided.