How to maintain attractive yield when interest rates fall

It's no secret it has been a busy few years in the interest rate market. In April 2022 the RBA cash rate was still languishing at 0.1%, an astonishing low rate it had been sitting at for almost 18 months. Just over a year later, in June 2023, the cash rate stood at 4.1%, representing the equivalent of 16, quarter of a percent, cash rate increases. One further hike in November 2023 took the cash rate to 4.35%, where it still stands today. One of the big winners from this jump in interest rates has been people with cash on term deposit (TD).

We are now at a turning point for interest rates. Some economists believe more rate hikes are required to fully temper inflation, yet many corners of the economy are clamouring for cuts to help ensure we don’t enter a protracted slowdown.

Despite the fact that RBA rate cuts are likely to be a few months away we have already started to see many banks cutting their TD rates. ?Recently we saw the latest of the Big 4, ANZ, cut their term deposit rates by up to 0.9%. The best rates from the Big 4 now stand at c.4.75% and that is only for periods of less than one year. This is partially due to the outlook for rates, but also due to the fact that the banks source some of their funding from offshore. Some of this funding will have become cheaper as rates have been cut in other countries, notably the US. This is great news for mortgage holders with some slightly cheaper mortgages becoming available however this has also pushed down term deposit rates. Having said that, there are still a few TD opportunities from smaller ADIs offering returns of c.5%. That is a solid return for an investment that is effectively government guaranteed (sub $250k).

So, why not simply fill the defensive part of your investment portfolio with TDs yielding up to 5%? Having a portion of your portfolio in cash, or near cash, always makes sense and while the headline returns look attractive at present, you have to consider refinancing risk. This can work in your favour in a rising interest rate environment, but it will work against you as rates fall. You may be able to secure a 6 – 12-month TD with a rate close to 5% now, but what will the return be when you look to roll the TD? Nobody knows, but it seems highly likely that returns will continue to drift lower.

Enhance your income with bonds

In contrast, high quality bonds can provide more stable returns over a longer time frame. You have the opportunity to lock in attractive returns now, which will help to effectively ride out the interest rate easing cycle. If you’re looking for predictability of income there are fixed rate bonds (which pay a known fixed income) offering returns of 5% - 6% over the next 5 – 10 years. Alternatively, the income on floating rate bonds is calculated as a margin over the Bank Bill Swap Rate (BBSW). BBSW moves broadly in line with the cash rate over time, so you can also expect your income to move up and down with the cash rate. With the cash rate expected to fall, now might not seem to be an opportune time to invest in floating rate bonds. However, the income on some of these bonds is currently very attractive, in the 7% - 7.5% range. Yes, the income is likely to fall but we will need to see several 0.25% rate cuts before the income falls below 6%. So if you think the RBA cutting cycle might be relatively shallow then you may well be better off allocating to floating rate notes.

The chart below reflects this situation together with the markets expectations in relation to moves in the cash rate. You can lock in an income of 6% through a fixed rate bond issued by QBE (BBB rated) or alternatively you can secure a higher income now through an ANZ floating rate issue. The ANZ issue will generate a comfortably higher income over the period, with the QBE bond only closing the gap at the beginning of 2026.

What is the additional risk in bonds vs term deposits?

Term deposits are very safe and it tends to be an investment truism that higher returns come with higher risks. In the case of investment grade corporate bonds this additional risk can be quantified. Rating agency Standard & Poor’s publishes an Annual Default Study which shows the annual expected default rate on different rating bands. The A and BBB rating bands offer the best balance of risk and return (see table below). AAA rated bonds have the benefit of effectively having a 0% default rate however the returns reflect that and are very low, lower than TDs in some cases. For example, Australian Government bonds (AAA) are offering c.4.0% for a 2-year bond and c.4.49% for the 15-year maturity. ?In A and BBB rated bonds you take a small amount of additional risk to generate a meaningfully higher return.

Longer term returns of 5% - 6%+ in A and BBB rated bonds are available yet the average annual default rate in A rated bonds is 1 in every 2,000 bonds and in BBB it is 1 in every c.700. So, yes, there is some additional risk but it is very small, especially when compared to the additional return on offer. Even in the most extreme circumstances, going back to 1981, the default rate was 1% in BBB - 1 in every 100 defaulted. So the additional risk is still well contained even in a highly stressed environment.

How flexible are bonds vs TDs?

Prior to the GFC it was not too hard, or too expensive, to break term deposits however regulators saw this as a vulnerability in banks. If investors started losing confidence in a bank they could pull their funding by breaking TDs, and that just put the banks under even more liquidity pressure. Now it is much harder and more expensive to break TDs. This provides certainty of funding for banks, but it leaves little flexibility.

In comparison, bonds have an actively traded secondary market. The liquidity in large investment grade bond issues is relatively good which is a significant advantage over TDs.

Now is the time to move cash into bonds

TD investors have been one of the big winners from higher interest rates but that tide has already started to turn. While there are still some attractive returns on offer in TDs the opportunity to lock in higher returns for longer, thereby avoiding short term refinancing risk, makes investment grade bonds very attractive at this point in the cycle. You will be well rewarded through the higher returns available in bonds, especially given the relatively nominal increase in risk. The greater flexibility of bonds, through a liquid secondary market, also provides some peace of mind if you’re wary of locking capital away for extended periods.

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