Do term deposits still stack up?

Some investors face a tough decision now, and in the months ahead, as their five-year term deposits which had been yielding almost 8% back in late 2009 start maturing.

Should the deposits be rolled over for another five years, at a time when the cash rate is at historic lows and term deposits pay just over half their old rate, or are there viable alternatives in generating interest from cash?

Currently, the best rates for 60-month term deposits pay 4.6% interest annually. They are available through the retail arm of the rural and agribusiness bank Rabobank, and two small credit unions – People’s Choice Credit Union and Police Bank.

Among the ‘big four’ banks, Westpac has the most appealing rate at 4.35%, though it was cut earlier this month (June 6, 2014) from 4.55% “following downward moves from competitors”, a day after the European Central Bank cut interest rates to record lows in Europe. That’s a far cry from the 7.8% Westpac was offering in 2009-10, illustrated below.

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Lower returns from cash have translated to investors piling more of their assets into shares and property in the hunt for yield. The amount of cash and term deposits held by SMSFs has fallen from a peak of 32% in June 2012 to 28% in March this year, according to the Australian Taxation Office (ATO).

Nevertheless, holding a certain percentage of cash and term deposits remains a must for many investors seeking defensive assets in a diversified portfolio. The Australian government guarantees authorised deposit-taking institution deposits up to a cap of $250,000.

Indeed, while SMSFs may be devoting higher proportions of funds to riskier assets, the total amount of term deposits continues to climb: in April this year Australian households deposited $656.9 billion in authorised deposit-taking institutions, up from $429.9 billion in April 2009, data from the Australian Prudential Regulation Authority (APRA) shows.

The outlook on rates

For these investors, the decision of how to best generate interest on their holdings needs to be analysed in the context of the likely direction of interest rates and various strategies that can be employed to get the best interest rate return over the long term.

As Adam Carr highlighted on Friday (Can the Fed stop printing?), it’s clear that economic conditions remain fragile after the US Federal Reserve’s chair, Janet Yellen, said interest rates in the US would remain low “for a considerable time” last week.

Given the mounting number of concerns about Australia’s economy, most economists don’t expect the Reserve Bank of Australia to begin lifting the official cash rate until next year. And when it does come, it’s unlikely to be dramatic.

“There’s a bunch of reasons why the rate tightening – when it comes – will be relatively gradual,” says Shane Oliver, head of investment strategy and chief economist at AMP Capital.

Oliver points to the fading mining boom; Australia desperately needing to find other sectors such as construction and export-focused industries like tourism to fill the void. Because these industries require a lower Australian dollar to fire up, he says the RBA will be reluctant to push interest rates up fast.

Is a 4.6% return from five-year term deposits, therefore, the best solution?

“It’s a pretty low rate to lock your money away for five years,” says Dr Chris Caton, chief economist for BT Insights.

That being said, Caton points out the market has already factored in a rise in interest rates into five-year term deposits – meaning it’s not necessarily the case the deposit rate will go up quickly.

Moreover, when the cash rate does go up, term deposits may not rise at the same speed and are unlikely to reclaim their previous heights, says Oliver. This is because Australia’s banks are increasingly turning to overseas markets, such as Europe, to source cheaper funding – reducing their reliance on term deposits.

“Back in 2009 when those [term deposit] deals were around, it reflected an environment when banks were under intense pressure to raise more money from deposits,” Oliver says.

Since then term deposits have remained substantially above the cash rate, unlike before the GFC when they were below.

A staggered approach to deposit rates

While the trade-off between term deposits and shares has clearly shifted in favour of the latter, Caton and Oliver agree it can be a viable strategy to stagger investments into five-year term deposits.

For example, an investor holding a total of $50,000 in cash in 2009 could have designated $10,000 to an institution’s five-year term deposits in each of the five years to 2014, with the remaining funds held in shorter-term deposits or cash. Once the fifth year comes around, the term deposits mature and can be rolled over each year – providing more flexibility and liquidity.

However, don’t be caught needing to exit a term deposit early. A financial institution is likely to charge a hefty early withdrawal fee or cut the interest rate that applies to the account, depending on how far a customer is through the fixed-term period.

An alternative to staggering investments into term deposits is to allocate funds to high-interest online accounts or bonus interest/reward saver accounts. According to Roy Morgan research published earlier this month, these high-interest alternatives are now the most popular savings accounts among Australians.

The survey found that, while the number of Australians who hold a term deposit has fallen by 36,000 (2%) over the last 12 months, the number holding high-interest at-call online cash accounts has risen by 102,000 to 5.88 million and the number holding bonus interest or reward saver accounts has surged by 709,000 to 4.55 million.

These high-interest online alternatives often have a base rate plus a bonus rate, subject to conditions. Moving funds out of these accounts usually incurs a fee and reduces the interest payable for that month, and there is normally a requirement to insert cash into them each month.

Westpac currently offers up to 3.71% per annum with its Reward Saver account, while its eSaver account earns up to 3.82% per annum for the first three months which then goes down to 2.5%. ME Bank, which offers the best headline rate at 4.6%, has a variable interest rate (currently 2.9%) plus a fixed bonus rate of 1.7% per annum for the first five months if you open an everyday account with the bank.