Are term deposits risky?
Christine St Anne  |  30/11/2012Text size  Decrease  Increase  |  

Christine St Anne: It's not surprising that many investors flocked to term deposits during the global financial crisis, given their perceived safety. But how safe are these assets? Today I am joined by Ibbotson's Brad Bugg to discuss the volatility behind term deposits. Brad, welcome.

Brad Bugg: Nice to be here.

St Anne: Brad, term deposits are perceived as safe assets. Are they actually more volatile than investors think?

Bugg: Well, I think, from a risk perspective, term deposits have done a very good job of preserving your capital, and post the GFC I think that has been the number one concern of investors.

But one thing I think they have ignored is the volatility of the income, which comes from a term deposit. We are at now in an environment where the RBA is starting to cut the cash rate, and as a consequence the banks are starting to bring those term deposit rates down. The RBA has cut cash rates by 1 per cent over the last 12 months and term deposits have come down to a similar degree.

So, investors who were investing in term deposit 12 months ago, the income which they are going to get from the new term deposit could be anywhere from 20 per cent lower to a third lower. So, we think that's a big risk for pensioners who are relying on that income to survive.

St Anne: You mentioned the volatility of income, are there any other risks behind term deposits?

Bugg: I think one of the biggest risk is complacency. In 2007 investors could get term deposit rates of 7 per cent to 8 per cent, and they could lock that in for five years. So, that was an easy decision for investors because it gives you that capital preservation and the nice income going forward. But now sort of we are in a period where sort of term deposit rates are quite low and people have gone back to term deposits because they've given the outcomes that they wanted in the past, but that's meant they've ignored some good opportunities where they could have protected their capital, but still get a better return and from that you could have look to Australian or global government bonds, for instance, which gave you a return of more than 10 per cent over the last 12 months.

So, I think, there is that complacency that people go back to what they know, but there are other opportunities that they are missing out on. So, we think investors need to take a more dynamic approach where they look to vary their allocation to different assets, depending on the opportunities that are present at the time.

St Anne: So, how does the risks behind term deposits impact the retirement plans for investors?

Bugg: Well, retirees look to the income that's coming from these term deposits to pay the bills whether to pay the water bill, the utility bill. These bills are going up at some quite alarming rate in many instances. And with reinvestment of term deposits probably for the last 12 to 18 months, each time they've rolled over term deposit they've been getting lower income from that term deposit.

So, just to give you an example, Westpac offered a five-year term deposit at 8 per cent many years ago. Had you locked that in that would be fantastic, but now you are looking at rolling that term deposit over in a couple of years time at a rate which could be half that. So, if for instance you had all your money in that, you are going to see the income that you rely on to live halved, which I don't think is an outcome a pensioner would look to.

St Anne: Brad, you mentioned bonds, what other assets can investors look at besides term deposits and bonds that can give them some sense of capital protection?

Bugg: Well, I think, term deposits have been very good from that perspective in protecting investor capital. Bonds have also done a good job in a falling interest rate environment, and we don't think that's going to be the case going forward.

So, we look to just plain vanilla cash, having money in the bank account because that does preserve your capital, but it also gives you that flexibility to capitalize on opportunities should other assets fall and start to present some interesting valuation.

So, we think that sort of cash gives you a good option value which you are not getting with term deposits because your money is locked up for the life of that term deposit.

St Anne: Brad, so ultimately is there a role for term deposits?

Bugg: I think so, because term deposits do give you a certainty of income, but we wouldn't recommend that you have all your investments in term deposits. We recommend sort of having a diversified portfolio and varying those allocations over time, and having the biggest allocations to those assets which give you the best reward for your risk, and at the moment West is starting to see the reward for risk portfolio from term deposit being not as advantageous as some other asset classes out there at the moment.

St Anne: Brad, thanks so much for your time today.

Bugg: Not a problem.

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