Time to revisit bond funds?

One of the positive consequences of the financial crisis is that banks have offered depositors much better deals, particularly for those fortunate enough to lock in the high term deposit rates of a few years ago. Market and regulatory pressures have forced banks to increase the stability and maturity of their funding base: hence, the more aggressive pricing of deposits.

This has led many investors to question why they should invest in bond funds when they can earn high returns in term deposits. That was a reasonable question to ask a few years ago when there was a wide gap between term deposit rates and bond yields. Circumstances have moved on since then. We believe that it is now important for investors to think carefully before locking up their funds in a term deposit rather than investing in a high-quality bond fund.

One important change is that yields in capital markets have risen as the Reserve Bank of Australia has increased the cash rate. At their peak in mid 2008, banks were offering 1 year term deposits at around 8% as shown in the chart below, making them very appealing to investors. Since that time 1 year term deposit rates have fallen to around 6%. This is now less than the yield investors could earn from a well diversified high quality bond fund such as the PIMCO EQT Australian Bond Fund which is currently yielding 6.7%. So the choice between investing in a bond fund and a term deposit is now very different to what it was a few years ago.

The other thing that has changed is that banks have done a good job in restructuring their funding sources. Deposits have grown quickly and banks have increased the maturity of debt on issue in the capital markets. Deposits now account for 60% of banks’ liabilities, close to their long-run average. This is well above the low point of 51% immediately prior to the crisis. While there is no doubt that banks will face greater scrutiny around their funding, much of the hard work in transforming their balance sheets has been done. So there is less incentive for banks to bid aggressively for deposits, particularly in an environment when their lending is growing slowly and other funding avenues like covered bonds will become available.

There is also likely to be a limit to the household sector’s willingness to increase its exposure to bank deposits. The counterpart of the rapid increase in deposits on the liability side of bank balance sheets is a large increase in deposits on the asset side of household balance sheets. As a share of financial assets outside superannuation, deposits are back to where they were over twenty years ago. Households now have almost 50% of their financial assets in bank deposits, up from around 30% a decade ago.

Taken together, the recent major changes in bank and household balance sheets may mean that the aggressive pricing of terms deposits is close to an end.

When weighing up the pros and cons of investing in term deposits and bond funds it is also important to consider the additional benefits that bond funds provide to portfolios. Term deposits and bond funds are very different investments. For one thing, investors’ funds are not locked away in a bond fund. More importantly, when interest rates fall, as they typically do during periods of economic and equity market stress, the value of a bond fund will rise. This provides an effective form of insurance against a downturn in the economy. Of course, a bond fund is marked to market daily and while the value can go up or down, there is flexibility to liquidate the investment at any time. The chart below shows the history of returns for the UBS Australian Bond Fund.

How does this insurance work? When an individual invests in a bond fund they are buying a future stream of fixed income payments. When interest rates fall, the present value of those future payments increase. This “duration” effect provides significant diversification benefits in a portfolio. This is often forgotten when investors simply compare the rates on offer on term deposits with the running yields on bond funds. The chart above shows that in every significant period of market stress in the past 15 years – the Asian crisis in 1998, the 2000/01 US recession, the onset of the Iraq war in 2003 and the financial crisis of 2008 – bond funds generated significantly higher returns than term deposits. In doing so, they helped add some insurance to portfolios.

In summary, now is a good time to revisit the role of term deposits and bond funds in your portfolio. On a running return basis, the distinct advantage that term deposits had a few years ago has been eroded. Investors can therefore enjoy the liquidity and diversification benefits that bond funds bring without foregoing income returns.

The above article has been sourced and adapted from UBS Fixed Income – Australia.

Important Information

The above information provides an overview or summary only and it shouldn’t be considered a comprehensive statement on any matter or relied upon as such. The above information doesn’t take into account your personal objectives, financial situation or needs. It’s important for you to consider these matters before making any financial decision and I recommend you seek help from a financial adviser.