A common question from investors new to fixed income is why invest in bonds when you can earn a good return from term deposits? There are many reasons why a bond portfolio is preferable to term deposits, but the main outcome investors seek is the capacity to earn greater returns for a marginal increase in risk.
In the current low interest rate environment, many investors who rely on income from term deposits are struggling to maintain their current lifestyle. With inflation around 2.5%, if your clients are earning around 3-4% on term deposits, the real return is close to zero after tax. Investors are seeking additional investment options to maintain regular income. If investors are confident that the issuer of the bond will continue to operate, additional return can be offered by moving down the capital structure into bonds and taking some additional risk.
| | Term Deposit | Corporate Bonds |
| Yield | 4.00% | 5.50% |
| Interest earned over 4 years | $80,000.00 | $110,000.00 |
| Liquidity risk | Penalty charged if broken | Can be sold |
| Interest rate risk | Fixed rate only | Fixed or floating rate |
| Income generation | None - interest on maturity | Quarterly or Semi-annual coupons |
| Minimum amount | $1,000.00 | $10,000.00 |
| Inflation protection | None | Inflation linked bonds |
| Volatility | None | Low |
The table above compares the differences between a 4 year term deposit and 4 year corporate bonds.
By investing in corporate bonds, investors have the capacity to earn a regular income stream through quarterly (or semi-annual) coupons and an additional $30,000 over 4 years.
Bond investors also have the capacity to sell bonds while term deposit investors wanting access to funds prior to maturity will be penalised, reducing the expected return.
There are substantial benefits in addition to increased return that can be achieved by incorporating more strategy into your investment portfolio with bonds.
- Bonds provide regular income (coupons may be quarterly or semi-annually) and term deposits only pay income at maturity
- Bonds can be bought or sold at any time (subject to liquidity).
- Term Deposits are only available in fixed rate format, which increases interest rate risk, while bonds are available in fixed and floating rate format
- Some bonds are inflation-linked, meaning that if the Australian economy goes through a protracted hike in inflation, the bonds protect the underlying capital investment, a feature that no term deposit offers.
- Bonds provide an avenue for investors to have access to a wide range of companies that often do not have listed equity or whose shares are not denominated in Australian dollars
- Many investors prefer term deposits if they have smaller capital amounts. Previously, investing in direct bonds required minimum investment amounts of $500,000. FIIG has been able to increase accessibility to parcels of $10,000 with a portfolio size of $50,000.
Given the variety of bonds available (fixed rate, floating rate and inflation-linked), a diversified investment in a portfolio of bonds may reduce volatility in your clients’ investment portfolios over an interest rate cycle.
Fixed rate bonds pay a fixed pre-determined rate of interest or coupon which is set at the time of issue and does not change during the life of the bond. These investments are ideal when the economy contracts (when property and equity usually underperform) and interest rate expectations move lower. If interest rates fall, fixed rate bond prices will rise, providing a capital gain. The opposite is also true, if interest rates rise, fixed rate bond prices will fall. So a fixed rate bond allocation will act to smooth overall portfolio returns.
Assuming a company survives, whatever happens to the price of a bond over its term, investors receive - the face value ($100) at maturity- this helps to minimise volatility in bonds. As the bonds moves closer to maturity its value will move back to $100.
Floating rate notes, because of the way they are structured, typically protect a portfolio when interest rates are rising. FRN coupons will also increase to reflect the market’s expectations of higher interest rates, thus typically outperforming fixed rate investments such as term deposits and fixed rate bonds when interest rates are moving higher. FRNs are also more capital stable than fixed rate bonds, in that their prices do not move up and down to the same extent.
Inflation linked bonds can be attractive in low interest rate markets. The bond prices can be lower than the value of the bonds and there are some corporate inflation linked bonds that are paying interest of over 4 per cent above CPI, which is very attractive given good term deposit rates are around 4 per cent and there's no adjustment or allowance for inflation should it start to rise.
Please see our current model portfolios or contact your FIIG Relationship Manager for more information on bonds.