The allure of higher interest rates and certainty of returns from term deposits is strong, but the income advantage of bonds over term deposits remains clear, writes Pendal Group’s head of income strategies Amy Xie Patrick.
THE RESERVE BANK held the Overnight Cash Rate steady at 4.35% on May 7 for the fourth consecutive meeting.
At first look, this makes 12-month term deposits seem attractive.
The 2022 “everything sell-off” still haunts many investors, while the allure of higher interest rates and certainty of returns is hard to turn down.
At the margin, however, investors we speak to are starting to wonder whether there is more to life than term deposits — even in a higher interest rate environment.
Our answer? Yes!
Term deposit returns in 2023
Since 2022 was such a volatile and disappointing year for both defensive and risky assets, many investors found it better for their peace of mind to leave their capital in cash products at the start of 2023.
After all, one of the reasons bonds and equities had sold off together in 2022 was because inflation had been a problem and so interest rates had been raised across the globe.
In Australia, the RBA raised the Overnight Cash Rate from 0.1% to 3.1% in the space of six months.
This meant that at the start of 2023, 12-month term deposit rates on offer with the major banks exceeded 3.5%.
Since the economic backdrop looked far from straightforward, one-year return rates of between 3.5%–4% looked pretty attractive to lock in.
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Indeed, last year was eventful and volatile.
US regional banks threatened to bring another credit crunch into the global financial system. Chinese property developers continued to be in dire straits with no sign of rescue from Beijing. Inflation continued to be a concern despite passing its peak. And at one point in the year, it seemed like the rise in bond yields was about to bring a repeat of 2022.
Yet, what we see below was the final scorecard of asset class performance in 2023, including 12-month Australian term deposits.
What Figure 1 highlights is that while the decision to turn to term deposits made complete sense following the market chaos of 2022, it is one you then have to stick with for the whole year – even as you see opportunities unfold again.
In short, locking in certainty isn’t a bad thing in certain environments, but it’s good to understand that this would also lock out opportunity along the way.
In today’s environment, what else should investors consider instead of term deposits?
It might be helpful to separate the market environment into four simple regimes, as depicted in Figure 2.
These regimes can be either high or low in volatility, as well as high or low in the interest rate backdrop.
The top-left quadrant of the diagram was a lot like the post-GFC period, where interest rates were low and headed ever lower. Most of that period was benign in terms of market volatility, minus a few short and sharp events.
Term deposits were unattractive in that regime and most investors went searching for yield in riskier assets.
In such a regime, high-quality (investment-grade) floating rate corporate bonds are likely to do a better job at generating income than term deposits.
Not only does a low-volatility backdrop support asset classes such as credit, but a floating rate bond will also not be hurt by interest rate rises should the RBA start to tighten monetary policy.
The bottom-left quadrant of the diagram is like the Covid crisis of 2020, even though it was relatively short-lived. Interest rates were low at the start of the pandemic, but they were slashed further as global central banks tried to provide economic stimulus.
Government bonds were useful to own back then, even if it seemed pointless to own them before the volatility hit since the interest they carried was so low. It seems that no matter how low interest rates get, government bonds still rally when the economy comes under stress.
Term deposits were also not a bad option if capital preservation was all that was required, but they could not have delivered the capital gains that government bonds did during that troubled period.
In the bottom-right quadrant, we see a period of both high interest rates and high volatility. This is a lot like 2022, where being in cash or term deposits would have at least saved you from the drawdowns in other major asset classes.
However, high volatility can set in because of concerns about growth as well, which would prompt central banks to cut interest rates in a hurry. Here again, term deposits cannot offer that upside.
The last quadrant is on the top-right and is probably closest to where we are right now. Interest rates are high, but volatility is low.
Term deposits are easily beaten by fixed-rate corporate bonds in such an environment because not only will yields be higher, but the fixed-rate nature of those bonds will also help to deliver capital gains should rates and yields fall from here.
Figure 3 is a stylised illustration* of how a 12-month rolling term deposit, a five-year floating rate corporate bond, and a five-year fixed rate corporate bond are all likely to perform in a gentle RBA easing cycle.
For simplicity, let’s assume that each of these investments are taken on in a passive way.
For the bonds, the investor holds them to maturity and for the term deposit, they are simply rolled at the end of every year into a new 12-month deposit.
The income advantage of bonds over term deposits is clear.
Even at today’s higher interest rates, the higher yield from corporate bonds (the credit spread) helps bonds generate a better income stream for investors.
At lower interest rates, only the fixed-rate five-year bond can continue to deliver a consistent income stream.
By years two or three, that income stream will look very generous compared to market interest rates that will be on offer.
What is an “active income strategy”?
In each of the four quadrants illustrated in Figure 2, active income strategies have a role to play. Let’s first define what an active income strategy is.
In the first instance, the role of any income strategy is to deliver income. Therefore, the “income engine” of these strategies needs to be made up of assets that pay regular income.
You might think of shares that pay a dividend, but those dividends are at the discretion of the company which is not contractually obliged to pay dividends (or any set level of dividends).
That’s why Pendal’s income strategies like to rely on corporate bonds for their income engine.
Here, we mean high-quality corporate bonds with defined coupons. Hybrids don’t count because once again, they have a provision that allows issuers to skip coupon payments should certain conditions arise.
The income engine itself ought to be actively managed – a high-volatility regime calls for a more cautious approach to taking on more corporate exposures and vice versa.
But other levers are needed on top of that.
When yields are low and volatility is high, government bond exposures are beneficial, but only up to a point. As the reflationary episode after the pandemic showed, you don’t want to overstay your welcome in government bonds when yields are super low.
Equally, higher yields are not a shoo-in for government bonds either, as the last two years have shown.
Active portfolio management to help time when and how much government bond exposure to take should be a key feature of active income strategies. After all, government bond exposures serve different purposes for income funds (as seen in the different quadrants of Figure 2).
In some cases, it is to provide diversification and defensiveness to the credit risk in the portfolio. In other cases, it is to help boost income returns on top of what the income engine is able to generate.
Lastly, we believe an active income strategy should offer investors a compelling way to chase returns when there is more upside on offer.
Rather than adding on more credit exposures to the portfolio, which will have negative quality and liquidity consequences down the road, active income strategies ought to be able to stay liquid while participating in more of the upside.
That liquidity is not only beneficial to investors who may want constant access to their capital, but also beneficial to the agile positioning of the portfolio.
An income strategy that pursues additional exposures only by piling on more corporate bonds will find it hard to dial that back if the market takes a sudden turn for the worse.
That’s not a big problem if it’s only a short-term hiccup, but it could be difficult to resolve should a longer-term bear market set in.
On the other hand, an active income strategy that pursues the addition of exposures through only liquid means will be able to switch off that exposure very quickly and efficiently should there be an unexpected shock.
If it turns out to be only a short-term hiccup, the liquidity of those exposures permits a quick restoring of exposures. If it’s something more fundamentally negative, then those timely risk-reductions would have been hugely beneficial for preserving capital for investors.
Conclusions
Higher interest rates in 2023 made term deposits seem attractive. But despite a volatile year for markets, term deposit returns looked disappointing versus bonds and equities.
Term deposits are great for capital preservation, but by locking in your rate of return, you may also be locking out a lot of upside opportunity.
It may be helpful to consider active income strategies as an alternative to term deposits.
Their income engines comprise corporate bonds offering a compelling yield advantage to term deposits, even if interest rates stay where they are for a long time.
The other active levers within Pendal’s income strategies are also designed to mitigate risk and improve returns regardless of the market backdrop.
Best of all, unlike term deposits, investors won’t be locked in if better opportunities present themselves along the way.
This article was first published here.
