“We have just renewed the fixed interest part of our portfolio for six months”

A term deposit and a bond both fall under the category of fixed incomes. They are relatively risk-free investments that you can use to diversify and strengthen your portfolio. And like all investment options, they both come with their fair share of pros and cons. To maximise your returns, you need to first understand how investment bonds and term deposits function in a real-world environment.
In 2022, Bonds took a leave of absence in providing security for investors. The S&P U.S. Aggregate Bond Index, which tracks the performance of publicly issues U.S. debt, returned -12.03%. This left a lot of investors scratching their heads thinking bonds were as safe as houses!

So how do bonds really work and is now the time to rethink them as part of your portfolio.

Term deposit rates are going higher and risk-free. So why own bonds?

A term deposit functions like a high-interest savings account. You put your money into a term deposit and it will achieve higher returns than a regular bank account. An investment bond is a way of lending money to a government or a corporation. Because the entity owes you money, you can collect regular interest on the bond. When the bond has fully matured, the government or corporation must repay the original sum of the loan. Both are considered safe places to store your money, but term deposits are generally considered even safer than bonds.

Both term deposits and bonds can be important parts of a strong portfolio because they provide consistent returns. In the case of a term deposit or a government bond, the investor is virtually guaranteed a payout up to $250,000.

For a term deposit, it’s the interest rate that matters most when determining the yield. Term deposits generally lock in that interest rate at the very start, making it easy for investors to plan ahead. However, term deposits are an illiquid investment strategy. Once the money is locked away, an investor will have a difficult time cutting the term short. Bonds generally give investors the option to sell prior to maturation, making them more flexible and ultimately giving some investors more peace of mind if they run across an emergency situation.

However if interest rates rise you can be caught short holding longer duration bonds.

What is the outlook for rates?

To understand how fixed income assets will behave from here, one needs to understand the outlook for rates. Here are the key points to consider:

  1. What is the recession risk? This recession risk is starting to diminish as more positive economic date emerges. Longview economics latest view is that US rally in the past six months, stock market sentiment has switched (from maximum bearish to bullish) and industrial production has expanded (for the past 5 months, i.e. since December), perhaps brought about by the sudden reopening of China (and reinforced by $400 billion of extra liquidity during the March banking panic). With that, our ‘bull-bear’ models for the stock market (which we use as a sanity check) have started to signal a new cyclical bull market.
  2. Inflation rates forecast.  If interest rates have increased sufficiently to curb inflation then a pause in increasing rates seems more likely which then means we may start to see rate cuts early in 2024. However Central banks including the Fed and the RBA cannot start declaring victory on inflation. The US is in better shape at the moment because they went hard and early on interest rates.
    What is the forecast for inflation
  3. Banking crisis and  liquidity. In simple terms, monetary tightening via rate hikes and quantitative tightening (shrinking the Federal Reserve’s balance sheet) is an exercise in pulling liquidity from the market. The reduction in liquidity sloshing around the market crimps growth and thus eases pressure on the Fed to maintain rates at a restrictive level.

“With the outlook for inflation coming down, it supports the argument that you’re going to get diversification for investing in bonds.”

Risk-free term deposits are currently paying out upwards of 4.5% in Australia. That still equates to a negative real return of a few percentage points given Aussie CPI is running at 7%, but it’s nonetheless attractive in a volatile market.

What do the big 4 banks think interest rate will go

Big four bank’s cash rate forecasts:

  • CBA: Peak of 4.35% by August 2023, then dropping to 3.35% by November 2024
  • Westpac: Peak of 4.60% by August 2023, then dropping to “below 3%” by end of 2025
  • NAB: Peak of 4.60% by August 2023, then dropping to 3.10% by November 2024
  • ANZ: Peak of 4.60% by August 2023, then dropping to 4.10% by end of 2024

Source: Rate City 2023

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