Record low cash rate forces investor ultimatum

Promoted by Smarter Money Investments

With the Reserve Bank of Australia cutting its official cash rate to a new record-low of 2.25 per cent, savers, investors and retirees are faced with two choices: either leave their cash wallowing in sub-three per cent deposits that fail to cover inflation after tax, or search for superior solutions that can beat vanilla deposits.

Something to be aware of is that many ADIs have changed the conditions of their term deposits and require depositors to give 31 days’ notice if they want to get their cash before the maturity date. This is in response to the introduction of a new liquidity coverage ratio requirement.

Under the new rule, ADIs must maintain an adequate level of high-quality liquid assets that can be converted to cash to meet liquidity needs for 30 days. To determine the appropriate ratio, banks must estimate their net cash outflow over 30 days under stressed conditions, with higher runoff rates to apply to less stable deposits. Retail deposits are divided into "stable" and "less stable" portfolios.

Cash outflows related to term deposits with a residual maturity or withdrawal notice period of greater than 30 days will be excluded from ratio calculations if the depositor has no legal right to withdraw deposits within 30 days. Banks are now targeting deposits that can't be withdrawn before 31 days. Over the past couple of years, several ADIs have launched notice accounts, which allow regular deposits and have no maturity date but require the depositor to give notice before making a withdrawal.

With the new rule taking effect on 1 January 2015, most other ADIs have changed the terms and conditions of their existing term deposit products. In the past, depositors could break the term and get their money out at short notice, usually paying a fee. Now, they must give 31 days’ notice, unless they face hardship.

Increasingly advisers have been reducing portfolio exposures to ASX-listed hybrid securities after some price volatility in recent times. With many clients fully exposed to bank stocks, advisers are reluctant to move to overweight positions, notwithstanding many that have quality blue-chip portfolios in place to provide consistent levels of franked income.

Advisers say that the current challenge they face is to secure reasonable levels of income from investments for clients, whilst maintaining a conservative or defensive investment risk profile in this part of their clients’ total portfolio asset allocation.

Portfolio manager Darren Harvey from Smarter Money Investments says for advisers and clients who are willing to educate themselves, it’s possible to have the best of both worlds – safe net returns of around four per cent annually via a portfolio of “active cash” investments without undue increases in risk.

Mr Harvey argues that investors can avoid the traditional capital instability associated with “fixed-rate” bonds by investing in a high quality and liquid portfolio of Australian bank-issued “floating-rate” notes, which have interest rates that reset every month or quarter off the bank bill rate that closely tracks the RBA cash rate.

A five-year fixed-rate bond is like investing in a five-year term deposit, Mr Harvey says. In contrast, floating-rate notes are like one-month or three-month term deposits and remove the long-term punt on the direction of interest rate changes that you make with fixed-rate bonds.

“A bank-issued floating-rate note is similar to an at-call deposit or very short term TD,” he continues. “They typically have very low capital risk: Australian floating-rate notes have historically displayed volatility of less than one per cent annually compared to four per cent per annum for fixed-rate bonds.

“We fundamentally believe the Aussie fixed-income market is inefficiently priced and there are opportunities for aligned active managers with principals – as opposed to agents – who own the business to add value for clients looking to beat cash,” Mr Harvey exclaims.

Mr Harvey concludes with a warning about the sleeping catastrophe risks in the fixed-rate bond market. “If inflation ever returns it could wreak havoc on old-school bond funds,” he says. “A one percentage point (ie. 100 basis point) increase in 10-year Australian government bond yields, which are currently over 300 basis points below their average level since 1993, would inflict an 8.3 per cent loss on holders of these assets, which are often assumed to be ‘defensive’.”