Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 20

Term deposit investors did not understand the risk

Investors in term deposits (TDs) have taken a significant risk!

As interest rates have fallen, TD rates have declined sharply as well. Therefore, people who expected TDs to give them a reliable income stream are facing a challenging time. How has this come about? What lessons can be learned about risk management from this experience?

Relatively few investors have the comfort of holding TDs that will continue to earn 5.5 – 6.0% for a few more years. This rate or better could have been locked in until around 2016 by investing in 5 year deposits. In fact, Westpac was still offering 8% for 5 years in 2010, a deposit that does not mature until 2015. However, over 90% of all TDs have been taken out for no longer than 12 months. The rates being earned by most investors have fallen nearer to 4% or less.

This presents investors with a significant decision. Do they keep rolling into new six month rates and accept the sharp drop in income? Do they move into a longer maturity, where rates of 4.5% or more are still on offer? Or do they shift into higher risk, but potentially higher returning, assets?

Duration risk ignored

In effect, the majority of investors who have moved into TDs have created portfolios that have short duration.  In fact, they have been positioned very short. The duration of the average TD holding seems to be around 0.5 year. That is at least 4 years shorter than the typical managed bond fund, and a similar amount shorter than a 5 year maturity TD would have been.

Some readers might not be familiar with the term ‘duration’, and it’s not a word often used in relation to TDs. Readers who have heard the term probably understand that it has something to do with bond price volatility. But since the value of a TD doesn’t fluctuate, how can an investor be said to have taken a duration position by holding TDs in their portfolio? And what does it have to do with reinvestment risk?

Yes, it’s true that duration is a measure of how much a bond’s price changes when its market yield changes. As market yields change, long duration bond prices fluctuate more than short duration bond prices. But duration is also relevant to one of the most important drivers of the longer term returns that a fixed interest and/or TD portfolio will deliver. The key is to understand why the word used for ‘bond price sensitivity’ is one that also means ‘length of time’.

Fixed interest investing is a series of cash flows

The link is as follows. Both bonds and TDs are a series of cash flows: regular interest payments and a maturity payment. The term to maturity is very important, but it isn’t the full story. At its heart, duration is a measure of the weighted average time for the payment of all the asset’s cash flows, not just the last one at the final maturity date. A bond or TD maturing in X years’ time has a duration that is less than X because the regular cash flows that are paid before the final maturity date are taken into account.

Therefore, an investor who owns a short duration asset, whether it’s called a bond or a TD, receives all the cash flows from that security more quickly than if they owned a long duration asset. This exposes them to more significant reinvestment risk. They have to deal with the fact that their investment has become cash sooner than if they’d taken a longer position.

This risk cuts both ways, of course. If someone invests in a longer term bond/TD, then yields in the market fall, they are ‘happy’. They have locked in a higher rate than is now available. They don’t have to reinvest at those lower rates for a longer period of time than if they’d only made a short term investment. On the other hand, if after they invest the market makes higher yielding options available, they are ‘sad’. They won’t be able to take advantage of the higher rates until much later, missing the extra income along the way.

Some investors have intentionally positioned themselves short over the past few years. They chose to have cash available around now as they expected rates would be higher. In their case they have, as it turned out, made a wrong call on the economy and interest rates. They will be disappointed, but it was intentional on their part to take the risk.

However, I suspect that many investors were unaware of this issue. They may have thought that by owning short term TDs instead of equities their income was protected from future fluctuations. In reality they were actually exposed to significant risk.

When rates fall, short duration strategies result in lower total returns than longer term positions. This shows up quickly in a bond fund by its return being below its index or a competitor’s longer duration portfolio. But it also shows up in the fact that cash flows have to be reinvested at lower rates sooner and the total return in the medium term ends up quite a bit lower.

‘Duration’ is one of the jargon terms used by fixed interest managers and it may be tempting to regard the word as just technical mumbo-jumbo best left to the experts. However, the duration of your income portfolio is a significant driver of your longer term investment outcomes, whether you are in a bond fund, own direct fixed interest securities or hold TDs.

While duration creates capital price volatility in assets that are marked to market, it also drives the length of time for which current interest rates will be paid. If the goal of an investor is simply to avoid capital volatility, then short bonds or TDs are ideal. But if the investor’s income needs are paramount, then the real question to ask is whether you have locked in a decent rate for long enough. How soon will you be faced with the reinvestment decision?

Whether you invest in bonds or TDs, being intentional about the duration of your portfolio is more likely to deliver investment outcomes that meet your objectives than ignoring it.

Technical note

The link between this way of thinking about duration and the more common reference to bond volatility is that, when bond prices change, it is essentially the market’s way of measuring the quantum of ‘happiness’ and ‘sadness’ from changing market yields that I mentioned in the article. An example should clarify what I mean.

If you invest $10,000 in a five year bond (or TD) paying 4% annually you will be paid $400 a year interest. This is $2,000 in total over the five years. The duration of this asset is 4.45.

Yields then fall in the market to 3%.  Your investment is now earning $100 a year more in interest payments than someone entering the market at the lower rate. In nominal terms, that’s a total of $500 of ‘excess’ interest earnings over the life of the investment. When each of the $100 amounts is valued using 3% as the discount rate, this works out at $458. This is the amount by which the value of your asset increases, a capital gain of 4.6% of the $10,000 outlay that you made.

What about a rise in yields? If after you’ve locked in 4% the market moves to 5%, you will earn $100 a year less than a new investor is able to do. Your bond is revalued downwards by the NPV of those amounts, or $433 – a capital loss of 4.3%.

In neither case have you really ‘made’ or ‘lost’ money. At maturity your bond or TD will still repay the $10,000 in capital that you paid for it. The mark-to-market is simply measuring your good fortune or bad luck in regard to the interest payments you are receiving compared with what’s subsequently available.

If you invested only for one year, the price changes will be much smaller than these. This is because either the extra interest or the shortfall that you’ve locked in is only for that shorter time period and is thus a smaller amount.

The point of all this is that the reason duration is relevant to bond price volatility is because when you value the interest income you are earning compared with current market rates, the time period over which you are earning that income is a major factor in the valuation. If you invest at a high interest rate, but only for a short time period, then you will only earn that rate for a short time period. The value of your investment won’t fluctuate much, but you will have to reinvest your cash flows relatively quickly. You are thus exposed to market fluctuations and over the longer term your investment outcome will be affected.

Warren Bird was Co-Head of Global Fixed Interest and Credit at Colonial First State Global Asset Management, and is now an External Member of the GESB Board Investment Committee and a consultant and writer on fixed interest, including for KangaNews.

 

RELATED ARTICLES

Are income funds just arbitrage funds?

A fortune built on defying the pull of theory

'FOMO' is driving residential property prices, not yields

banner

Most viewed in recent weeks

10 reasons wealthy homeowners shouldn't receive welfare

The RBA Governor says rising house prices are due to "the design of our taxation and social security systems". The OECD says "the prolonged boom in house prices has inflated the wealth of many pensioners without impacting their pension eligibility." What's your view?

Three all-time best tables for every adviser and investor

It's a remarkable statistic. In any year since 1875, if you had invested in the Australian stock index, turned away and come back eight years later, your average return would be 120% with no negative periods.

The looming excess of housing and why prices will fall

Never stand between Australian households and an uncapped government programme with $3 billion in ‘free money’ to build or renovate their homes. But excess supply is coming with an absence of net migration.

Five stocks that have worked well in our portfolios

Picking macro trends is difficult. What may seem logical and compelling one minute may completely change a few months later. There are better rewards from focussing on identifying the best companies at good prices.

Let's make this clear again ... franking credits are fair

Critics of franking credits are missing the main point. The taxable income of shareholders/taxpayers must also include the company tax previously paid to the ATO before the dividend was distributed. It is fair.

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

Latest Updates

Investment strategies

Joe Hockey on the big investment influences on Australia

Former Treasurer Joe Hockey became Australia's Ambassador to the US and he now runs an office in Washington, giving him a unique perspective on geopolitical issues. They have never been so important for investors.

Investment strategies

The tipping point for investing in decarbonisation

Throughout time, transformative technology has changed the course of human history, but it is easy to be lulled into believing new technology will also transform investment returns. Where's the tipping point?

Exchange traded products

The options to gain equity exposure with less risk

Equity investing pays off over long terms but comes with risks in the short term that many people cannot tolerate, especially retirees preserving capital. There are ways to invest in stocks with little downside.

Exchange traded products

8 ways LIC bonus options can benefit investors

Bonus options issued by Listed Investment Companies (LICs) deliver many advantages but there is a potential dilutionary impact if options are exercised well below the share price. This must be factored in.

Retirement

Survey responses on pension eligibility for wealthy homeowners

The survey drew a fantastic 2,000 responses with over 1,000 comments and polar opposite views on what is good policy. Do most people believe the home should be in the age pension asset test, and what do they say?

Investment strategies

Three demographic themes shaping investments for the future

Focussing on companies that will benefit from slow moving, long duration and highly predictable demographic trends can help investors predict future opportunities. Three main themes stand out.

Fixed interest

It's not high return/risk equities versus low return/risk bonds

High-yield bonds carry more risk than investment grade but they offer higher income returns. An allocation to high-yield bonds in a portfolio - alongside equities and other bonds – is worth considering.

Sponsors

Alliances

© 2021 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.