Why Aren’t Term Deposits Working Anymore?

17.10.19 Investing By Anthony Hourigan
Why Aren’t Term Deposits Working Anymore?

The headline above is a very common question that I hear all too regularly. It’s usually followed with a question along the lines of: “is there a better alternative that I don’t know about?”. The short answer to this question is: yes. The purpose of this blog is to highlight and explain some other options available to investors that may be a more attractive alternative. As with everything there are pros and cons, and it is up to the individual investor to decide which is most appropriate for them.

We all know why term deposits are leaving investors / savers dissatisfied at present with record low interest rates, but let’s take it a little further and show what it actually means in real terms. A quick search of term deposits available in the current market tells me the highest interest rate I can get in a term deposit is about 2.05% p.a. for a 12-month deposit. In nice round numbers, if I stick $100,000 in that term deposit and redeem it one year later it will have returned $2,050. Pretty unimpressive.

The sad thing is, it’s even less impressive than that, for two main reasons: Consumer Price Index (CPI), commonly known as inflation; and tax.

CPI

In basic terms, CPI measures the movement of the cost of a basket of goods to the consumer, i.e. inflation. For the most recent quarter, inflation sits at 1.6% year-on-year. In practical terms, this means something that cost you $100 this time last year now costs you $101.60. This is nothing new, and the rate of inflation varies over time. The long-term inflation target of the RBA is between 2-3%.

Tax

There is tax owing on the $2,050 interest made in the term deposit that was tied up for 12 months, and the marginal rate of tax will vary between individuals. For illustration purposes, we’ll assume a marginal tax rate of 30%. So, on the $2,050 interest, you owe the ATO $615, leaving you $1,435.

Now to tie inflation and tax together to understand what your real rate of return is, i.e. how much more can I afford as a result of the investment?

The net return of $1,435 is equal to 1.435% and we know that inflation is running at 1.6%. Subtract inflation from your after-tax return and the best term deposit on the market has returned negative -0.165% over 12 months. That’s right. The real value of your investment, or ‘what can my capital + returns buy me now?’ has gone down! This is a new phenomenon for Australians, because interest rates have never been this low, but it is something that we need to address in terms of our own saving and investment.

The higher your tax rate, the worse this is. For example, if you’re in the top tax bracket paying 47% (including the Medicare levy), the returns are as follows: $2,050 minus $963.50 = after-tax return of $1,086.50 or 1.0865%. Factor in inflation of 1.6% and this is a negative return of -0.5135%.

No wonder investors are looking for alternatives!

Alternatives

Fortunately, there are several alternatives to term deposits, and in fact there are many more today than there were a couple of years ago. Many are listed, so being traded on the open market means they are not tied up for a predetermined period, like a term deposit for example. Furthermore, you are free to pull the investment at any time without penalty – just be aware you will have to pay execution costs.

Capital notes

One of the more widely used listed securities is the capital note, which is a hybrid security issued by institutions (for example banks) and pay a rate of return on face value. These securities pay dividends, known as coupons, usually including franking, which rank ahead of dividends on ordinary equities. That is, the institution must pay all capital note coupons before they can pay any dividends on ordinary equities. These instruments are typically far less volatile than the underlying equity of the institution issuing them. Their rate and frequency of interest payments is pre-determined by the issuer and is usually set at a rate over and above a benchmark. To illustrate how the instruments work in reality, we’ll look at the CBAPD (this is just the code that the instrument trades under on the ASX).

CBAPD is a capital note that was issued by Commonwealth Bank in September 2014. The bank set the interest payments on these instruments using the 3-Month Bank Bill Swap Rate, plus 2.8% p.a. paid quarterly. At the time of issue, in September 2014 the 3-Month BBSW was 2.7%, meaning the instrument was paying holders 5.5% p.a. paid quarterly. Setting the floating rate gives the issuer the flexibility to adjust payments in line with interest rates, and having the margin over-and-above gives the security holder the confidence that regardless of which way interest rates move, they will always receive more than the benchmark.

Fast forward to today, and as we all know, interest rates have moved south. At time of writing, the 3-Month BBSW is at 0.83%, meaning that this particular instrument is paying holders 3.63% p.a. (3-Month BBSW + 2.8%) for those holders who purchased at ‘face value’ i.e. $100. Because these instruments are listed, their prices will move up or down as traded on market to reflect what the market deems a fair yield. In the case of the CBAPD, it is currently trading at $101.43 which implies a yield of 3.58% if you purchase it at these levels. By comparison, in 2016 the price of CBAPD was pushed down to a low of $85.29 (when the 3-Month BBSW was at 2.28%). This had the effect of pushing the yield on CBAPD up to 5.96%.

Figure 1 below shows the relative performance of the CBAPD to Commonwealth Bank’s underlying (equity) share price since CBAPD has been listed. You can see the lack of volatility in the capital note versus the common equity. The trade-off is that the common equity pays a higher dividend (currently around 7.8% for CBA inclusive of franking), but in a market downturn you would expect the capital note not to move much, whereas the CBA shares would go down in value.

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