Tired of term deposits? here are three alternatives

Reserve Bank Governor Phillip Lowe could not have been any clearer the other week. “The Board is not expecting to increase the cash rate (from 0.10%) for at least three years”.

And with the RBA buying three year government bonds at a yield of 0.10%, and announcing a program to buy $100bn of 5 to 10 year Government and State Government bonds over the next 6 months, yields starting with a big figure of “0” are now the norm.

For term deposit investors, this means an interest rate with the big figure of “0” is here to stay. Three months around 0.40%, six month terms around 0.55% and for a year, 0.75%.

So what are the alternatives to term deposits?

Of course, with term deposits being effectively “government guaranteed” up to $250,000 due to the operation of the government backed Financial Claims Scheme, this means taking on more risk. There is no such thing as a free lunch and if you want a higher return, you need to take on more risk. Risk means both the potential for loss and the volatility of the return.

This is where diversification becomes even more important because you don’t want to make the mistake of blowing all your capital on one bad investment. Typically, as investments get riskier, you invest less.

And owning low risk investments such as term deposits and higher risk investments in hybrids, corporate bonds or credit funds is not mutually exclusive.  A balance between low risk and higher risk will typically deliver the optimum return.

Here are three alternatives.

1.     Exchange traded bond funds (ETFs)

There are several exchange traded bonds funds from issuers such as Blackrock’s iShares, Vanguard, Van Eck and Betashares. Most track an established fixed interest index and are passively managed.

Broadly, there are three categories of funds: those investing in government bonds; those investing in investment grade corporate bonds and those investing in higher yielding, non-investment grade bonds.

The first category includes industry leaders such as iShares Core Composite Bond (ASX:IAF) and Vanguard’s Australian Fixed Interest ETF (ASX:VAF). Because these funds art mostly investing in government and semi-government bonds, they are very secure with negligible credit risk. Accordingly, the yield to maturity (YTM) is low at around 0.60% (see Table below). The weighted average maturity (WAM) of the underlying bonds is long at 7 years, meaning that they carry considerable interest rate or duration risk. If yields rise, the mark to market value of bonds fall, and the price of the ETFs will also fall.

Alongside the yield to maturity (YTM) is the running yield. While this is a measure of the first year’s income, because it is so much higher than the yield to maturity, the capital value of the ETF will fall over time as the underlying bonds get closer to maturity. Overtime, the running yield will also fall.

The second category are funds that invest in investment grade corporate bonds. It has two sub-categories – Australian denominated corporate bonds and global investment grade corporate bonds that are hedged back into Australian dollars. The former includes the iShares Core Corporate Bond (ASX:ICOR) and Vanguard’s Australian Corporate Fixed Interest ETF (ASX: VACF). They have a yield to maturity of a touch over 1% and a weighted average maturity of about 4 years. The funds investing globally and hedging back into Australian dollars (to remove the foreign exchange risk), IHCB and VCF, have weighted average terms of almost 10 years. They are yielding around 1.5%.

The final category are funds investing in non-investment grade bonds. Because it is higher risk, the yield to maturity is considerably higher at almost 4%. iShares IHHY, which is currency hedged, is an example.

2.     Hybrid Securities

ASX listed hybrid securities, which are typically issued by banks, are popular with many investors. As the name implies, they are a “cross” between an equity and a debt security. They have “equity” features in that they count as capital for the issuing banks and rank almost at the bottom of the food chain. If the issuing bank gets into financial trouble or there is an industry wide financial crisis, investors could lose some or all of their capital.

They have “debt” like features in that they pay a regular quarterly distribution. When redeemed, similar to a bond, investors should get back the capital value of $100. With the distribution, it floats at a fixed margin over a benchmark interest rate, usually the 90 day bank bill rate. If the fixed margin is 3% and the 90 day bank bill rate is 0.10%, investors will receive a gross distribution of 3.1% for the quarter. If the bank bill rate subsequently increases to 1%, investors will receive a gross distribution of 4% for that quarter.

These securities are complex investments and as the old adage goes, “never invest in something you don’t understand”. To learn more, see ASIC’s MoneySmart website.

Like many securities, hybrid securities were punished during the March Covid-19 market meltdown as panicked investors rushed for the exit. They then rallied hard, with the trading margin going under 3% on some of the major issues as investors searched for yield.

New supply has hit the market over the last couple of weeks, and trading margins have moved higher. Bendigo has launched a $460m issue of Bendigo Capital Notes paying a margin of 3.8%. To trade under the ASX code of BENPH, it has approximately 6.5 years to the call date and 8.5 years to the expected redemption date. The offer closes on 24 November. Bank of Queensland has also been in the market with a $250m issue of BOQ Capital Notes 2.

The pick of the issues (albeit it pays a lower fixed margin of 3.4%) is Westpac’s Capital Notes 7. The jumbo issue (of around $1.4bn) will trade under the ticker WBCPJ and has a term of 6.3 years to the call date and 8.3 years to the expected redemption date. The offer, which includes a securityholder offer to Westpac shareholders and noteholders, is scheduled to close on 30 November.

National Australia Bank has also announced an issue of NAB Capital Notes 5. To pay a margin of 3.5%, they have approximately 7.0 years to the call date and 9.0 years to the mandatory conversion date. The offer is scheduled to close on 11 December.

An alternative to investing in hybrids directly is Betashares Active Australian Hybrids Fund (ASX:HBRD). Chris Joye’s Coolabah Capital Investment is the investment manager. Management fees are 0.55%pa plus the potential for a performance fee.

3.     Credit Funds

Higher risk, but with the potential for higher returns, are listed credit funds. They are called credit funds because most of the risk is credit risk, that is, the ability of the borrower to repay. Typically, they keep the duration fairly short and don’t take on material interest rate risk.

There are eight funds listed on the ASX – four that invest offshore in corporate bonds, loans and other investments and then hedge back into Australian dollars, and four that invest locally. Each has a target distribution return, often expressed as a margin over the current Reserve Bank (RBA) cash rate. Distributions are typically paid monthly (see table below).

To achieve the higher returns, some of the funds invest in “non-investment grade” securities and debt.  More colloquially referred to as “high yield” or sometimes unkindly “junk” bonds, this means that the probability of capital loss is higher, so the manager’s approach to portfolio construction, security selection, risk management and diversification become critical. 

If investing in higher yielding funds, diversification across manager and asset type is generally recommended.