Term deposits: taking the wheel

Stephen Hart takes a look at the term deposit market and asks: what's next for the sector?

The term deposit market has recently seen the arrival of some interesting product enhancements, one of which is the flexi-term deposit.

Flexi-term deposits enable the investor to switch between fixed and floating rates over the life of the product. Investors even have the ability to set the interest rate for part of the term.

A flexi deposit is a bona fide deposit product that investors (both small and large) can use to structure the interest rate, term and order of fixed and floating to suit their needs.

Probably the best way to describe the options available is to use an example.

An investor can say to the providing bank: ‘I want a three-year term deposit with a fixed interest rate of approximately 7 per cent for the first year with conversion to a floating interest rate for the remaining two years’.

The bank will do its sums and strike a floating margin of approximately 50 basis points over 90-day bank bill swap for the last two years. If the investor is happy with this they can proceed to lock it in.

The key options this product provides to the investor are:

• The ability to choose the term and order of the periods under fixed and floating rates — obviously there are two options here being a fixed period followed by a floating period or vice versa;
• Ability to choose the term of the deposit likely to be between two and 10 years; and
• The ability to set the interest rates (or margin over the benchmark) that best suit the investor.

Why use a flexi-term deposit?

This product is suitable for investors seeking flexible interest rate pay offs that suit their circumstances. Reasons could include:

• Tax planning — if an investor wants to bring forward or ‘back-end’ income;
• Hedging — if an investor knows with certainty they have a fixed or floating commitment for a prescribed period of time (or indeed one that switches between the two) they can hedge or better match the interest rate risk to some extent;
• Managing cash flow — if an investor requires a specific cash flow for a period they can use this product to match the requirement; and
• To take a speculative position on the movement of interest rates — if an investor or his adviser has a view on the future direction of interest rates and believes the current swap curves or market expectations are wrong, they may use this product as a way of making a speculative bet.

Advantages

The primary advantages of flexi term deposits are:

• Flexibility to structure the interest rates/pay offs;
• They enable smaller investors to get access to floating rate deposits (for part of the overall term) which is generally difficult as most term deposits offer a fixed rate for the whole term;
• The flexi-term deposit maintains its status as a deposit which is eligible for the Government guarantee up to the maximum limit (currently $1 million until October 2011 but is likely to change after that date) and is afforded the depositor priority under the Banking Act ;
• They are typically issued by the larger, household names;
• They provide a mechanism for smaller investors to take a position on the direction of interest rates, which is generally not available and provides the potential for increased returns (although there is obviously risk involved here and appropriate advice should be sought);
• They can be available for investments from as little as $100,000;
• No direct fees charged; and
• They are offered with terms of up to 10 years which, typically, is longer than most other deposit offerings which tend to extend only to five years.

Disadvantages

The added complexity of this product attracts a few disadvantages, primarily:

• In the event the investor needs to break the deposit contract there could be break penalty fees in excess of the interest earned. In the event investors would suffer a negative return (ie, the loss of some capital). Typically, for a standard term deposit the break fees are relatively small reflecting only a portion of the interest earned with no potential for a loss of principal;
• When the product is being used for speculative purposes there is a risk that returns will be lower than investors could have obtained if interest rate markets move in a direction not aligned with the investor’s expectations;
• The investor may find the structuring aspect difficult to assess; and
• There is the possibility of law and regulatory changes during the term of a deposit.

Summary

This product enhancement is viewed as an interesting development in the term deposit market.

The ability of investors to tailor a term deposit to match their needs is a worthwhile proposition, particularly as an aid for taxation and cash flow planning.

Investors looking to use it as a speculative tool should ensure firstly, that they are fully aware of the attendant risks and secondly, that they are comfortable with the expected returns and comparison of those returns with the break even points for a standard term deposit of equal duration.

Stephen Hart is the head of planner services at FIIG Securities.