Term deposits are the go-to investment for most Australian's trying to turn their spare cash into an income stream. However, while they are still sought after, current low interest rates make their yield less attractive – especially once you factor in inflation.
But that has not reduced the number of people looking for lower risk, recurring income, and it has resulted in an increased appetite for investment grade bonds.
Bonds are a globally popular defensive asset class, but not all bonds are created equal – there are hundreds of different bond categories available, ranging from relatively safe (but low yield) government or treasury bonds to higher yield corporate bonds.
So should you invest in a term deposit or bond? Let’s take a look at the pros and cons of both options.
A yield is the expected return on an investment. For term deposits, this is the interest rate, which is typically locked in for the duration. Right now, cash rates are low and are expected to remain lower for longer in Australia.
Bonds are issued by companies or governments as a way of raising capital – they ‘borrow’ money from you as an investor, so it’s a form of debt. They are legally obliged to pay you regular interest (called a ‘coupon’) and once the bond matures they must return the face value of the bond to you.
This means the yield can be measured as the interest rate they pay you. But as bonds can also be traded on a secondary market, their prices can move up and down (although not by as much as shares in the same company) – giving you the potential for additional yield through capital gain if you choose to sell before the bond matures.
Because bonds are slightly more risky than term deposits, they tend to offer higher interest returns. But there are much wider variations on yield between government and corporate bonds – reflecting the perceived higher risk of a corporate bond investment.
The coupon rate depends on the credit strength of the issuer, expected inflation and interest rates, where the bond sits in seniority of claim (in the case of insolvency) and investor demand. This means issuers have the potential to offer higher yields despite a low interest environment.
As well as gaining potentially higher returns, bonds provide longer-term income certainty.
Verdict: Bonds typically offer higher yields than term deposits or cash rates, but different type of bonds will vary.
Term deposits are protected by the government guarantee on amounts up to $250,000 with each participating institution – and as such, are the safest investment you can make.
Bonds are classed as senior secured or unsecured debt, or subordinated debt, which places them high up in a bank capital structure. This means bond investors are prioritised over equity or hybrid investors if the issuer becomes insolvent.
As a result, there is a strong degree of certainty you’ll get your bond face value back at the maturity date. If a bond issue carries a higher risk of running into financial difficulties, you should expect a higher rate of return to compensate you for the additional risk you accept.
Verdict:Term deposits are safer than bonds – but bonds still offer more certainty than equities or hybrids.
Once you’ve invested in a term deposit, your savings are locked away for that fixed period, and if you want to access your funds you’ll find there’s a 31 day notification period for early termination – and you will forgo interest.
Bonds are more liquid, and can be bought and sold at the prevailing market price, in a similar way to shares. As a global bank, Citibank can bring buyers and sellers together from across the globe to trade on the secondary bond market, as well as offering direct stakes in new bond offerings.
When interest rates are low or falling, the bond’s face value may increase on the secondary market – and the cost of trading is relatively low. On the other hand, there is also the risk it will be priced at a discount.
Newly issued bonds generally offer greater potential for price appreciation and better liquidity.
Verdict: Bonds offer more flexible access to funds, but you need to monitor their value before you decide to trade.
Bonds also offer more diversification options, as a broad range of assets are on offer through bonds – from local corporations to global enterprises not available on the Australian share market, such as Apple, Intel and Coca Cola. Bonds also give you access to long-term income producing infrastructure (such as airports), universities and governments.
Generally, when equities underperform, bonds outperform – because when markets are unpredictable bonds look more attractive to investors – in fact, corporate bonds and Australian equities often move in opposite directions. So investing in bonds also helps you mitigate the risk of your equities portfolio.
Bonds come in many forms – fixed rate, floating rate, callable and step-ups, which are explained in 'Citi's guide to bond investing'.
While most bonds are issued as fixed rate, some investors may choose to diversify their bond portfolio with inflation-linked bonds (which hedge against rising inflation) or floating rate bonds (which pay variable interest). Callable bonds may be redeemed by the issuer prior to maturity, while step-up bonds will pay an initial coupon rate for the first period and then a higher rate for subsequent periods. This can be make them attractive for investors – especially if there’s any risk of credit rating downgrade.
Both bonds and term deposits offer control over the length of investment time, so you can also stagger your bond maturity dates or deposit terms to release capital at certain points – depending on your investment goals.
Verdict: Bonds can help you diversify your portfolio across different asset classes and markets – and manage the risk of inflation or interest rate changes.
Citibank offers direct investment in bonds to wholesale clients only, with a $50,000 minimum investment – which may be restrictive – wholesale investors have an annual income of over $250,000, or net assets in excess of $2.5 million - as certified by an accountant . If you’re interested in bonds as a retail investor, consider a managed fund – it will invest in bonds on your behalf.
Verdict: If you’re not a wholesale investor, term deposits are certainly easier to access, with lower minimum deposits.