How investors can use term deposits to increase returns while reducing risk

Stephen Hart and Bill Keogh explain how an anomaly in the term deposit market means clients can increase returns while reducing risk.

As a homeowner, what would you do right now if you found a fixed mortgage rate of 4 per cent? Switch out of your variable loan and lock the fixed rate in for as long as possible. It’s a no-brainer.

Well the same analogy can be applied to term deposit rates in the current market.

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Due to fierce competition and the levelling of the playing field via the government guarantee, the biggest banks in the country (and some smaller ones too) are offering some extremely attractive term deposit rates, all the way from at call out to five years, with the maturities past one year seeing the best returns.

The simple message is investors should take advantage of this unique opportunity and (a) move into term deposits and (b) fix in the rate for as long as possible, having regard to their need for liquidity.

This is a case of increasing return for reducing risk.

In a normal market, this should not exist, but it currently does and there are no catches.

As Figure 1 shows, term deposits rank at the very top of the capital structure and as such are among the lowest risk investments possible.

This is particularly true for term deposits issued by the major Australian banks, which are among the 14 highest rated banks in the world.

Throw in a government guarantee for amounts under $1 million up until October 11, 2011, and they are as close to risk free as you will ever get.

As you move down the capital structure risk increases, and the return required should rise accordingly.

As such, you will expect the return for term deposits to be below that of senior debt and significantly below that of subordinated debt.

However, the current market has been turned upside down and the best term deposit rates are materially higher than riskier senior and subordinated debt.

This is demonstrated in Figure 2, which plots the best term deposit rate (green) as a spread over the relevant BBSW/swap rate and compares it to the current spread that major bank senior debt (blue) and subordinated debt (red) is trading at.

The term deposit data is sourced from the Australian Term Deposit Index database, as available on, which covers more than 60 ADIs.

By way of contrast, the senior and subordinated debt trading margins are sourced from YieldBroker, and these encompass the four major banks.

This anomaly is unlikely to remain a permanent aspect of bank funding as it is irrational for lower risk deposits to pay more than higher risk senior debt, and even more than significantly higher risk subordinated debt.

For any investors who hold major bank senior or subordinated paper, if liquidity is not a primary concern, it will make good sense to sell those bonds and invest in term deposits.

In fact, anyone holding senior paper of any corporate yielding less than, say, 1.75 per cent to 2.00 per cent over the relevant swap should strongly consider selling those bonds and putting the money into term deposits, again if liquidity is not a concern.

The opportunity improves as the maturity increases and is another key reason why investors should consider locking in the longer-term deposit rates Figure 3 plots the BBSW/Swap curve (blue line) from 30 days out to five years against the best term deposit rate (green), both as an outright annual yield or annual interest rate.

The swap curve is the market’s expectation for future interest rates and, as such, incorporates future expected rate rises. As you can expect in a rising rate environment, it is positively shaped.

The green line, or best term deposit line, is significantly above the swap curve, remembering that before the crisis you could expect this to be on or even below the swap curve.

Moreover, as the term increases the differential increases, meaning you are getting an even greater reward for taking out long dated term deposits.

Again, it is important to understand that this analysis incorporates the impact of expected rate rises.

The latter point is more clearly demonstrated by the red line, which plots the difference between the best term deposit rate and the relevant BBSW/Swap rate.

At 30 days the differential is 1.55 per cent, but this rises steadily as maturity increases, particularly in the three, four and five-year range, where the difference is as high as 2.17 per cent.

While some liquidity premium is required to lock up your money, the rates on offer are exceptional, and the longer the maturity you take, the longer you are able to lock in these excess spreads.

If you could get a 4 per cent fixed mortgage rate, would you just lock it in for 30 days and hope the rate still exists in a month's time?

We expect over time that the best term deposit rate as a spread over BBSW/Swap will fall from around 1.5 per cent to 2.0 per cent at present to below to 0.5 per cent to 1.0 per cent.

The longer dated term deposits, which obviously have a longer lasting impact on the banks cost of funding, are expected to fall even further.

Prior to the global financial crisis, most term deposits were offered at a rate flat or below swap, not 2.0 per cent or more.

While we don’t expect to return to pre-crisis levels, it is plain to see that these elevated rates cannot remain when you consider mortgage rates are not much higher.

It is for this reason we recommend investors fix in now and for longer maturities.

From a credit risk perspective, a very interesting recent development has been that many of the best rates are coming from the majors and regionals, as competition for term deposit funds has increased.

This commenced late last year following Westpac’s announcement that it would increase its use of term deposits to fund its operations.

In addition, the expected Basel III and Australian Prudential Regulation Authority liquidity changes, which reward banks for holding longer term deposit funding, have seen increased competition for one to five-year term deposits, an area the major and regional banks have traditionally not focused on.

Despite the outstanding opportunity presented here, many investors are still looking for reasons not to move to term deposits.

Here are some of the more common concerns:

  • 'Why lock in now when rates are rising?' Yes rates are rising, but the term deposits are already priced off the swap curve, which has these anticipated rate rises incorporated. The Reserve Bank of Australia (RBA) cash rate is just 4.0 per cent and will have to increase in a linear fashion to almost 12.0 per cent in five years’ time for investors to break even between leaving money at call/in cash at the RBA rate and locking in a five-year deposit of 7.9 per cent.
  • 'It looks too good to be true — what’s the catch?' There is no catch, other than you do have to lock up your money for the term of the deposit. Not only are term deposits at the lowest end of the risk spectrum, those with less than $1 million will also have a government guarantee until October 11, 2011.
  • 'I can’t trade out — I need liquidity.' Term deposits can be broken and in many cases the break costs negotiated are not large. And while we agree that money is locked up, there is a cost for everything. A pick-up in return as high as 2.17 per cent over swap more than compensates for the lack of liquidity. We don’t recommend investors put all their money into long dated term deposits. Some funds should always be kept liquid for emergencies.
  • 'Why invest in term deposit rates now? I think completion is heating up and they will rise further.' This is possible but in our view unlikely. In fact, indices suggest that competition has started to fall slightly. In commonsense terms, these very expensive funds for the banks cannot last when you consider where mortgage rates are. We expect term deposit rates to come off, but remain significantly higher than pre-global financial crisis levels. Unfortunately for mortgage holders, we also expect that mortgage rates will be raised to address the rising cost of funds/squeezed net interest margins.
  • 'While the spread over swap looks compelling, the absolute yields available are still low.' Simply not true; 6.7 per cent for 1 year versus cash rates of 4.0 per cent is a very attractive rate. Going longer to five years, the rate jumps to 7.9 per cent, a very healthy return for a low risk investment.

Investors have the ability to increase return for reducing risk — a free lunch and with no catch.

The once boring world of term deposits is offering a rare opportunity for investors and retirees to lock in low risk, high yielding returns for as far out as five years.

This anomaly cannot remain in place for long. So act fast and lock in these excellent returns for as long as possible.

Stephen Hart is director of planner services and Bill Keogh is managing director of short-term money markets at FIIG Securities.

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