Cash plays a significant role in our lives. Most importantly, cash provides stability, liquidity, flexibility and comes with a government guarantee of up to $250,000 for bank deposits. Interest rates are approaching 0% after they began declining in 2008, so a new problem for some households and organisations has arisen - cash returns are negative after tax and inflation.
Why are interest rates low?
Low interest rates have been engineered by the Reserve Bank of Australia (RBA) to stimulate economic activity and inflation. By squashing returns on risk-free investments, households and organisations are encouraged to pursue higher returning (and, therefore, higher risk) opportunities. This leaves many with an uncomfortable risk/return trade-off decision. The good news is that it is possible to generate reasonably better returns than cash and term deposits without venturing too far up the risk scale.
Corporate bonds as an alternative
For the following exercise, a handful of well-researched fixed interest managed funds have been selected to create a portfolio of diversified corporate bonds. More than 95% of the underlying securities are rated as investment grade or higher. This means there is a low risk of default by any of the bonds’ issuing companies, because each has been assessed as having a strong capacity to meet its financial commitments.
As shown above, the portfolio would have generated an average return of 3.7% per year for the past five years, compared to 1.8% per year for the RBAs term deposit average rate (all terms).
The chart below shows the downward capital movement of the portfolio for the same timeframe. The maximum peak to trough fall for the portfolio was -1.8% in March 2020, which quickly reversed. This is modest compared to the corresponding 27% drawdown that the Australian share market experienced.
Take action – interest rates increases are not on the horizon
Low interest rates are likely to stay with us for quite some time, as high levels of debt (government and household), changing demographics and technological advances keep downward pressure on inflation. While we stress the importance of maintaining a healthy cash buffer to provide flexibility, there are higher returning alternatives that do not involve taking a significant amount of additional risk for funds not immediately required.
If you find your bank continually offers lower term deposit rates or you are sitting on a surplus of cash, please contact a BDO Private Wealth Adviser to review your options.
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