Why term deposits aren’t always the best choice

PIMCO's Peter Dorrian takes a look at term deposits and finds they may not be all they seem.

Most agree fixed interest (FI) investments provide a valuable role in a client's portfolio.

The low correlation between FI and other riskier asset classes was apparent throughout the global financial crisis (GFC) when fixed interest indices delivered positive returns while other asset classes cratered.

In addition, fixed interest's stable cash flows are important for Australia's ageing population.

That's why in the US and UK advisers equate a client's FI allocation to the client's age, so a 60-year-old investor will have a 60 per cent allocation with the remainder invested in growth assets.

In recent years, term deposits (TDs) have increased in popularity among financial planners and their clients as bank rates have climbed and the government guarantee creates an almost riskless opportunity.

Indeed, PIMCO recently surveyed over 200 financial planners and found on average, advisers allocate close to a third (29 per cent) of their client's FI portfolio to TDs.

But are they the best choice? I argue illiquidity issues; concentration risk and comparably poor performance should prompt advisers to think again. 

It appears the illiquidity costs of TDs aren't well understood. A recent survey from PIMCO found half of advisers categorise term deposits as cash with the remainder putting them in the FI basket.

Given cash is by definition liquid, it would appear some advisers aren't considering the implications of the illiquid nature of TDs.

The headline impacts of illiquidity are obvious -capital isn't available at call without incurring high costs. But it's also about opportunity cost. When cash rates fell to 3 per cent, term deposits offering 4.5 per cent seemed attractive.

Until they rose to 6 per cent leaving early movers locked in at lower rates for up five years.

Capital stability is an argument many use to defend term deposits.

But this is simply a function of their lack of daily pricing. In my previous example, if a term deposit yielding 4.5 per cent was marked to market in the face of an increase in comparable rates to 6 per cent, a capital loss would have been observed.

But owing to their illiquid nature, there is no requirement for daily pricing and so the investor can ignore daily movements and instead focus on the headline rate of return.

In reality, this is the same as buying and holding a bond. While daily pricing will show a decline in value (think of it as the opportunity cost discussed previously), if the bond is held until maturity, then like the term deposit, the variations in pricing are irrelevant.

The government guarantee of bank deposits has been another driver of TD demand in recent times. By lending to a bank or credit union, term deposit holders are bypassing institutional credit risk.

It's important to note once the guarantee ends (slated for 12 October. 2011), TD holders will again be subject to varying degrees of credit risk, which investors should be evaluating.

This leads to an important point regarding concentration risk. Just like a fixed interest fund would never invest 100 per cent of that fund with a single corporate (even if it was a top tier bank), investors shouldn't pile all their cash into one TD issuer - yet many do.

Notwithstanding the illiquidity premium that should be incorporated into TD returns, history proves fixed interest outperforms TDs for a commensurate level of risk.

The chart shows the growth in $10,000 invested in a five-year term deposit with a major Australian bank in July 2005.

At that time, the rate on offer was 5.20 per cent. The end result is a compounded return of $12,885.

Plotted against this is the return from the UBS Australian Composite bond index, which delivered $13,402. This represents a return of 6.03 per cent in a passive bond exposure versus 5.20 per cent for a non-diversified, illiquid exposure.

Active management can again improve upon this with PIMCO's Australian Bond Fund returning $14,272 over the same period (7.37 per cent, or 6.91 per cent after fees).

The TD return equation worsens when you consider redemptions.

Although break penalties vary, the chart also illustrates the payout to the investor applying the break fees associated with the TD in question.

Breaking of the term deposit to reflect the same level of liquidity in a corresponding bond fund yields less across all time periods.

As our survey showed, almost half of all financial advisers believe their clients don't fully understand redemption fees.

There is one further important point to consider. A truly defensive asset will be lowly or negatively correlated with riskier assets - performing well when they perform poorly.

TD returns are fixed i.e. the upside is capped.

In contrast, bond returns are not capped. If we were to witness another sell off in risk assets and a flight to quality, term deposits wouldn't capture the upside bonds do, limiting the downside protection within diversified portfolios.

As the government guarantee program draws to a close, careful credit analysis is required to differentiate between authorised deposit-taking institutions (ADIs) and a diversified approach will be needed to avoid concentration issues.

Furthermore, historical performance outcomes have been insufficient to warrant an allocation over either passively or actively managed fixed interest strategies, which offer the benefits of diversification and daily liquidity.

Peter Dorrian is head of global wealth management at PIMCO.