3 Reasons Why Bonds Make More Sense than Term Deposits Today
Volatile markets and rising interest rates have led to major asset allocation shifts over the past year. Many investors have built significant cash buffers to prepare for an impending downturn, parking their money in term deposits until they are ready to invest.
In our view, however, increasing cash buffers by investing in term deposits is not enough to achieve a truly efficient portfolio outcome. We believe investors should also consider bonds, particularly in an environment where we may be seeing interest rates hit their peak.
Here are three reasons why allocating to term deposits may lead to missed investment opportunities compared with bonds.
- Exiting term deposits early can be costly.
Unlike bond funds that offer daily liquidity, term deposits lock up money for a fixed period of time and require investors to make a “term” decision regarding their access and the interest rate earned. If you identify an attractive investment and want to withdraw your funds early, you may have to pay a penalty fee and only receive a proportion of the interest, or none at all. The cost may be around 25% of the income generated and so is something investors should consider. - Term deposits entail reinvestment risk as well as lack of flexibility when you need it.
Once the term deposit ends, reinvestment risk should be a consideration. With market pricing indicating that we are nearing the cash rate peak, there is a risk that interest rates will be lower in a year’s time. As such, you would have to reinvest at a lower interest rate than the current rate when the term deposit ends. Meanwhile, by locking up money for a 12-month term, you could miss out on the chance of investing in other assets when valuations are attractive. For those parking their money until they are ready to invest, this could entail missing out on potential opportunities. - Term deposits don’t offer the same diversification and capital appreciation potential as bonds.
Locking in a fixed-term deposit means forgoing the defensive attributes that bonds deliver in an environment of declining interest rates, such as in the event of an economic slump. Bonds prices typically appreciate as economies enter recession, which would help offset losses likely experienced in other parts of a portfolio – namely equities (as earnings decline) and real estate (as home prices depreciate) – making bonds a crucial element of a balanced portfolio. As Figure 1 shows, given today’s higher starting yields, bonds should offer strong downside protection if an economic downturn forces the Reserve Bank of Australia to start cutting interest rates.
Figure 1: Bonds would offer greater downside protection than term deposits in a downturn
Hypothetical example for illustrative purposes only.
In the analysis contained herein, PIMCO has outlined hypothetical event scenarios which, in theory, would impact the portfolio returns as illustrated in this analysis. In these scenarios, we evaluate various risk factors and apply a specific hypothetical market shock to each. We then multiply the impact of the shocks by the risk factor exposure in each portfolio. This allows us to model the potential impact on the performance of the portfolios. No representation is being made that these scenarios are likely to occur or that any portfolio is likely to achieve profits, losses, or results similar to those shown. The scenario does not represent all possible outcomes and the analysis does not take into account all aspects of risk. Interest rates are represented by the Australian 10-year government bond yield (Bloomberg AusBond Composite 0+ Yr Index).
Bond market valuations appear attractive as we near the cash rate peak
After significant repricing in 2022, bonds now offer investors the chance of earning the highest real yields in a decade as we approach the peak of the monetary policy cycle. At the same time, the market is signaling that a downturn is coming, reinforcing the case for holding bonds due to their defensive properties.
Bond market pricing shows that market participants expect short-term bond yields (on securities maturing in less than one year) to rise meaningfully, medium-term bond yields to move only slightly higher, and 30-year yields to fall. This creates an inverted bond yield curve — a downward-trending or “inverted” yield curve has historically signaled a recession (see Figure 2).
Figure 2: Inverted yield curves in Australia and the U.S. suggest tough times ahead
Past performance is not a reliable indicator of future results.
Now is the time to bolster portfolios with bonds
Loss aversion and herding behaviour can lead investors to hold excess cash even when fundamentals are not favourableFootnote1. Both of these biases can lead investors to allocate to term deposits instead of investing in bonds, even if it is not the best decision to meet their investment goals.
The most effective way for Australian investors to mitigate market uncertainty is to ensure they balance the growth assets in their portfolio with defensive assets such as bonds, since bonds should outperform in a risk-off scenario when equities and other risk assets decline. While term deposits may seem like a safe and stable option, bond funds can offer daily liquidity, greater diversification from equities and real estate, and the potential for better long-term outcomes in terms of income and capital appreciation.
Featured Participants
Disclosures
Performance results for certain charts and graphs may be limited by date ranges specified on those charts and graphs; different time periods may produce different results. Charts are provided for illustrative purposes and are not indicative of the past or future performance of any PIMCO product.
Diversification does not ensure against losses.
Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations, and unlike an actual performance record, do not reflect actual trading, liquidity constraints, fees, and/or other costs. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve.
Hypothetical examples are for illustrative purposes only. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. Hypothetical or simulated performance results have several inherent limitations. Unlike an actual performance record, simulated results do not represent actual performance and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated performance results and the actual results subsequently achieved by any particular account, product or strategy. In addition, since trades have not actually been executed, simulated results cannot account for the impact of certain market or financial risks such as lack of liquidity or the ability to withstand losses. There are numerous other factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results. No guarantee is being made that the stated results will be achieved.
There is no guarantee that these investment strategies will work under all market conditions and each investor should evaluate their ability to invest for a long-term especially during periods of downturn in the market. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown.
The material contains statements of opinion and belief. Any views expressed herein are those of PIMCO as of the date indicated, are based on information available to PIMCO as of such date, and are subject to change, without notice, based on market and other conditions. No representation is made or assurance given that such views are correct. PIMCO has no duty or obligation to update the information contained herein.
Optimized and optimal portfolios described may not be suitable for all investors and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.
Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.
The views and strategies described may not be suitable for all investors. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, accounting, legal or tax advice. You should consult your tax or legal advisor regarding such matters. Please contact your account manager for further information.
All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and low interest rate environments increase this risk. Reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Equities may decline in value due to both real and perceived general market, economic and industry conditions. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses.