What are the best alternatives to term deposits?

Term deposits

With term deposit rates currently ranging between 1% and 2% p.a., and the prospect of further rate cuts by the RBA, many investors are contemplating where to invest their cash. Most commentators and economists agree that it looks like the interest rate environment will be lower for longer. If that turns out to be true, term deposit returns won’t even keep up with inflation. Therefore, most people will need to consider alternative investments (e.g. retirees or young people saving for a housing deposit). However, there is one potentially costly mistake that people commonly make when doing this. That is the topic of this blog.

By the way, even if this doesn’t apply to you, it’s important to check that your parents aren’t making this potentially costly mistake. So, perhaps share this blog with them.

You cannot talk about returns without also talking about risk

Benjamin Graham, the father of value investing (and Warren Buffett’s teacher) said “The essence of investment management is the management of risks, not the management of returns.” This quote highlights the biggest mistake that investors make when considering alternative investments (to term deposits). They fail to consider risk.

Often, people may be tempted to invest in high-yielding Australian shares. As I highlighted in last week’s blog, Westpac (for example) currently offers a grossed up yield of nearly 10% p.a. That is hard to resist when you compare that to term deposit rates.

However, term deposits are almost risk free, especially if the amount is less than $250,000 and with a bank (ADI), as its guaranteed by the government. However, shares are one of the highest risk asset classes because they have a volatility rate in the range of 18% and 25%. This means that statistically, you should expect your investment returns to vary by this amount from year to year. For example, one year you might experience a 15% loss and the next year a 35% gain. Of course, it could be worse, and the market could crash. Share market and term deposits are at opposite ends of the risk spectrum.

Don’t put all your assets in a risky basket

The common mistake that people make is not considering their risk allocation. For example, Keith has been retired for 5 years and historically he had $350k invested in term deposits and $650k invested in shares. This asset allocation (35% in safe assets and 65% in risky assets) felt very comfortable to him. However, now his pool of “safe” monies isn’t generating enough income. So, if he invests this amount in high yielding shares, he’s making a big mistake (because typically, that asset allocation is too aggressive for a retiree.

At some point in our life (particularly in retirement), capital preservation becomes more important than investment returns. That is, avoiding losing money is justifiably more important than making money.

Telstra is a good example

Historically, investing in Telstra primarily for its high dividend yield was very popular trend. Over the past 10 years its grossed-up dividend yield has ranged between 5% and 10% p.a. However, spare a thought for the investors that chased high dividends in 2015 when Telstra shares were trading at $6 per share and the grossed-up yield was over 7% p.a. These investors have lost over 35% of the original value of their investment (which they may never recover)! Chasing yield, without any consideration of risk, is a recipe for disaster.

term deposits

So, what are the alternatives?

There are a few alternatives to term deposits that warrant consideration (I list five below). Before I get into the list, I have a few important points to make: 

  • I have discussed them in order of risk (from lower risk to higher risk);
  • It is likely that the best solution will be to use a combination of some or all of these alternatives (rather than picking one);
  • This is not an exhaustive list. There may be other alternative investments that might suit your circumstances better; and
  • Please do not act on the information contained in this blog alone. Its important that you receive independent, personalised advice before making any investment decisions.

1. Investment grade corporate bonds (3.5% to 4% p.a.)

With central banks cutting official rates all over the world, government and treasury bond yields (interest rates) have been falling over recent months and years. Currently, government and treasury bonds do not offer materially higher interest rates than term deposits. Therefore, we have to look to the corporate sector to receive a higher income.

An investment-grade rated corporate bond is relatively low risk, especially if the investor holds the bond to maturity (click here for a description of what a bond is). There are many Australian corporate bond index funds provided by managers such as Russell, BetaShares and Vanguard. These funds are yielding in the range of 3.5% and 4.0% p.a. and funds usually pay this income monthly or quarterly. Bond interest (coupon) rates typically move in line with the RBA’s cash rate, so if it cuts rates by 0.25% p.a. this year, it’s likely that these rates will also fall by 0.25% p.a.

You must be very careful picking which index funds to use. Things to watch out for include (1) concentration risk (indexing methodology) and (2) understand whether the bonds held are fixed or floating coupons and their duration as that could have an impact on capital values in certain market conditions.

2. Hybrid securities (≈ 4% p.a.)

Hybrid securities are typically issued by Australian banks. They are essentially a cross between an equity and a bond. Each security will have its own unique terms and conditions, and as such, two hybrid securities are rarely identical. As such, hybrid securities can vary significantly in terms of risks and returns.

To accommodate these risks, I prefer to use active investment management when investing in these securities (i.e. not indexing, which I usually advocate). The reason is that each security needs to be assessed and valued in order to work out if its worth investing in. Historically, hybrid securities have one third of the volatility as shares, much like bonds, so they are a lower risk investment. I mainly use a fund operated by BetaShares and Coolabah Capital Investments to make these investments.

3. Global infrastructure (≈ 3.5% p.a. + growth)

Infrastructure involves investing in businesses that own and operate high-cost assets such as toll roads, communication assets, electrical systems and so on. These investments usually generate predictable and stable incomes, particularly in a low interest rate environment.

As many countries have exhausted monetary policy initiatives (such as cutting rates and quantitative easing), in order to stimulate the global economy, governments will need to start (or continue) to loosen fiscal policy, which usually involves spending money on infrastructure. I highlight that Australia has started to do this too.

Infrastructure investments have historically paid a stable income yield of 3.5% p.a. with low volatility. Total returns over the past 10 years (i.e. income + growth) have been over 13% p.a. Things to consider include the level of diversification (industry and geographical) and currency hedging.

4. Global real estate (≈ 4.0% p.a. + growth)

Real Estate Investment Trusts and companies (REIT) are entities that derive most or all of their profit (EBITDA) from rental income. These tend to be listed companies in developed markets. As these types of entities tend to hold debt, REIT’s work well in a lower interest rate environment.

I tend to avoid investing in Australian REIT’s because they typically have too much exposure to retail property, and we all know what’s happening in retail!

International REIT’s have historically paid a stable income yield of 4.0% p.a. with low volatility. Total returns over the past 10 years (i.e. income + growth) have been over 12% p.a. Things to consider are very similar to infrastructure i.e. diversification and currency hedging.

5. High yielding shares

Of course, I have discussed the perils of moving money from term deposits into high-yielding shares above. However, one way to reduce the risk slightly is to buy a diversified basket of shares, rather than picking the shares yourself.

Many fund managers offer high-yielding products including Vanguard, BetaShares and iShares. These funds tend to hold between 20 and 60 companies. Grossed up dividend yields range from 5% to over 10% p.a., depending on the product.

Beware of solely focusing on income

As I discussed in this blog, it is often erroneous to invest purely just for income. It can result in a higher risk asset allocation. Instead, aiming for a combination of growth and income is often the most appropriate (i.e. safe) approach.  

Saving for a housing deposit?

If you are saving for a housing deposit (or something else), the above investment options are typically still appropriate. You can access many of these investments cost-effectively via Exchange Traded Funds (ETF’s) – here’s a list of all EFT’s in Australia. All you need to do is open an online share trading account (e.g. CommSec) and buy shares in the relevant ETF.

Different times require different allocations

If interest rates remain at historical lows for an extended period of time, then an increasing number of investors will need to look for alternative investments (to term deposits). There are many good alternatives. However, you cannot talk about returns without also talking about risk. Remember what Ben Graham said; “The essence of investment management is the management of risks, not the management of returns.” If you need help with this, do not hesitate to reach out to us.