By Fraser Richardson
“Doubt is not a pleasant condition, but certainty is absurd.” Voltaire (1694-1778)
If Voltaire’s observation is correct, it seems that absurdity is currently in vogue among NZ mum and dad investors who are flocking to invest their hard-earned life savings in term deposits.
After the barren term deposit rates of recent years, 2023 rates seem like manna from heaven, with some mainstream banks offering rates north of 6% p.a. for terms greater than six months.
Many NZ investors who prefer to inhabit this particular corner of the financial markets will be breathing a sigh of relief after the enforced belt-tightening of the last decade or more.
We can only hope there weren’t too many who restricted themselves to a diet financed by term deposit returns alone.
To be fair, term deposits do serve a useful purpose, and not only for banks seeking the cheapest source of funding.
Term deposits pose minimal risk of a loss of capital, although NZ doesn’t have any explicit form of deposit insurance. A scheme is due to be introduced in 2024 and is likely to insure up to $100,000 per depositor.
Term deposits provide certainty over the amount you will receive at the end of the term. For this reason they are useful when budgeting for outgoings you expect to incur at a particular point in the future.
With interest rates for cash in the region of 6% before tax, why not avoid the volatility that comes with stocks, and as the past two years have shown, even with bonds?
And with short-term interest rates still higher than long-term interest rates, why lockup cash in a longer term bond or bond fund?
It’s easy to sympathise with this point of view, especially given the recent bad run of returns from bonds, an asset class which normally serves as the solid bedrock of a portfolio.
It’s important for any long-term investor to have a plan in place that will serve you throughout your time horizon.
Consider what will happen if you invest in a 12-month term deposit paying 6% now, but12-month term deposit rates drop to 4% next year. That’s what’s called reinvestment risk, and it’s the reality of any investor who has anything other than a very short-term investment horizon.
Of course, term deposit rates may remain elevated, and you may be able to lock in a similar rate this time next year. But that’s not guaranteed, and remember that the key reason the RBNZ and other central banks have been raising policy interest rates is to induce a slowdown in the economy.
When the economy does slow down, the central bank response is normally to cut short-term interest rates. This has a flow on effect on term deposit rates.
The price you pay for the (relative) certainty of term deposits is not small.
Because term deposits are considered low-risk investments, the return they offer is also low. This is called the risk-return trade-off: investors can earn higher profits only if they accept a greater possibility of losses.
If you invested $100 today in a 6% p.a. term deposit for a 12-month term, and inflation ran at 7% per annum over the next 12 months, the $106 you receive at the end of the term (ignoring tax) would buy you a smaller basket of goods and services in 12 months’ time than $100 would buy you today.
Most New Zealanders pay tax on term deposit interest at their marginal income tax rate. For example, a taxpayer whose income puts them on a 33% marginal tax rate.
If you’re a higher rate taxpayer, term portfolio income entities (Term PIEs) can reduce the amount of tax you pay, with a maximum prescribed investor rate of 28%.
By comparison, managed funds that invest in shares and bonds are not, as a rule, taxed as heavily as term deposits. This is a not a straightforward area, but there is a clear tax advantage in these markets when measured as a percentage of total return. This is because in most cases, not all of the return is taxed.
The following chart illustrates the net return of term deposits vs three model portfolios made up of shares, bonds and cash:
Term deposits have their place, and they can be a useful holding bay for funds you plan to use in the near future, normally within the next two years.
But it would be short-sighted to see term deposits as a long-term solution for the large majority of investors, who are much better served by a portfolio that gives them diversified exposure to good quality shares and bonds.