27 Sep How to Prepare for Falling Term Deposit Rates

In recent years, cash has stood out among defensive assets, reclaiming its title as ‘King’ thanks to steep interest rate hikes by the Reserve Bank of Australia (RBA). Since the cash rate peaked at 4.35% in November 2023, savers have been able to access term deposit and high interest savings rates of 5% or more.

However, financial markets move in cycles, and cash’s high point has passed as inflation cools and economic activity slows. Leading 12-month deposit rates have already dropped by 20 to 65 basis points over the past six months, despite no change in the official cash rate.

The King is losing its crown as markets anticipate Australia will follow major central banks in cutting rates to stimulate the economy.

This shift poses a challenge for savers – particularly conservative retirees – who rely on interest income to sustain their lifestyles. As cash loses its lustre, we explore alternatives for investors seeking to maintain income while preserving capital.

The stinging impact of falling rates

You might be exploring income options out of curiosity, concerned about declining rates as your term deposit renewal approaches, or facing the end of a honeymoon period on your latest savings account.

Regardless of your situation, it’s crucial to understand how changes in interest rates can affect your purchasing power – particularly in retirement.

An illustrative example: Alina and Ken

Consider Alina and Ken, a risk-averse retired couple with $1.5 million invested in a term deposit earning 5% interest. This generates $75,000 annually, the exact amount they need to live comfortably and cover expenses for travel, dining, and leisure without touching their principal.

Their goal is to preserve their savings to pass on to their children to buy their first homes and make charitable donations.

However, things change when their 12-month term deposit matures. Upon renewal, they discover the best available rate is now 4.5%. A year later, the rate falls to 4%, cutting their income further. Meanwhile, the costs of their hobbies, meals, and insurance continue to rise due to inflation.

Here’s a breakdown of how these rate changes impact Alina and Ken’s finances:

 Source: Betashares. Assumes term deposits are renewed annually. ^Assumes a 3% inflation rate, based on the RBA’s target range of 2-3%. Calculations do not take into account taxes or fees.

By their third renewal, Alina and Ken have experienced a whopping 25% loss in purchasing power, driven by the combined impact of falling interest rates and rising living costs.

What are Alina and Ken’s options?

Under this scenario – and assuming they have no other income sources – Alina and Ken face the following choices:

1. Dip into their principal to maintain their current lifestyle, depleting the nest egg they hope to pass on.
2. Cut back on lifestyle expenses to match their reduced income and live “less comfortably” during their golden years.
3. Consider part-time work if they wish to preserve their savings while maintaining their quality of life in retirement.
4. Invest a portion of their capital in equities, introducing risk and volatility they may prefer to avoid.

Alternatively, Alina and Ken could consider other investment options that may allow them to generate attractive returns while offering a high degree of capital stability that is important to them. We’ll explore what these are in a moment.

Ideas for savers seeking attractive income

Our house view is that the RBA will likely start cutting rates in early 2025, joining the Federal Reserve, Bank of Canada, and Bank of England. This expected easing reflects weakening global economic conditions. While this is good news for mortgage holders, it’s a bit of a headache for savers.

We also expect banks to lower term deposit rates more than the cash rate in order to preserve and increase profit margins on the money they lend.

It’s understandable that many income-focused investors might hesitate to move into riskier assets like equities to offset declining term deposit returns. Instead, let’s explore more conservative options outside traditional bonds.

You might be surprised to find that the ASX ETF market has more than 50 cash and fixed income options for those seeking yield and stability. The market cap of these products has jumped 30% to nearly $30 billion in the past 12 months, and according to the ASX, they now make up approximately 15% of the domestic funds under management.

And for good reasons: Cash and money market ETFs allow investors to generate comparable returns to term deposits, all while helping investors maintain low capital volatility. For investors looking to maintain a reasonable level of income while taking on some additional risk, fixed income ETFs may provide options.

While not a bank account, cash, money market and fixed income ETFs allow investors to generate attractive returns with far greater access to ready liquidity. In the face of falling interest rates savers don’t need to stick with term deposits for their cash holdings. There may be other options that are better placed to generate income in the face of rate cuts. Here’s a breakdown of four options and their current yields:

1. Cash ETFs

Cash ETFs invest in deposits from Australian banks, offering attractive income that generally varies with the RBA cash rate. While not a bank account, cash ETFs allow investors to generate comparable returns to term deposits, but with far greater access to ready liquidity. Based on current data, a saver would need to lock up their cash in a term deposit, on average, for between 8 and 12-months with the major banks to get a comparable interest rate to one cash ETF.

2. Money market ETFs

Investors seeking an enhanced yield from their core cash allocation may consider cash and money market ETFs. Money market ETFs provides monthly income to investors by offering diversified exposure to not only Australian bank deposits, but also a range of more sophisticated money market securities usually only available to institutional investors.

3. Senior floating rate bonds ETFs

Senior floating rate bonds are a debt security issued by banks that pay a regular coupon (interest) that varies over time. These securities offer income at a variable interest rate and have historically had a high degree of capital stability.

4. Subordinated debt ETFs

Subordinated bonds are a class of debt security whose rights with respect to payment of income and repayment of principal rank behind (are subordinated to) other classes of debt. Subordinated debt ranks below senior bank floating rate notes but typically offers higher income potential.

Tips for playing good defense

Rather than sticking to term deposits, investors could consider options including, money market and fixed income ETFs. This strategy may help investors strike a balance between generating income and managing risk.

1. Diversify across categories

Just as growth investors diversify their portfolios, conservative investors should also spread their investments across various categories.

• Cash and money market securities provide attractive income on cash deposits and money market securities with high levels of capital stability.
• Fixed income securities for investors seeking higher returns and who are comfortable taking on some additional risk, and may comprise exposure to senior floating rate bonds, subordinated debt, other high-quality fixed income securities and income focused stocks, if risk appetite permits.

2. Match investments to goals

Align your investments with your specific goals and risk tolerance. Cash and money market ETFs provide high levels of capital stability and easy access to cash. On the other hand, senior floating rate bonds and subordinated debt ETFs can offer higher yields for those willing to accept more risk. Always read the PDS and TMD for any ETF you’re considering, and it’s a good idea to consider seeking advice from a financial planner who can assist you in making well-informed decisions.

3. Conduct regular reviews

Stay informed about the economic climate, and review and adjust your portfolio accordingly. In a rising interest rate environment, floating rate bonds (including floating rate subordinated bonds) and cash become more attractive as their yields vary with changes in the cash rate.

Please note any information provided is not a recommendation or offer to make any investment or to adopt any particular investment strategy. You should consider seeking financial advice before making an investment decision.

Conclusion

With the RBA poised to cut rates and term deposit yields slipping, conservative investors will need to tap into a broader toolkit to maintain steady income.

By considering strategies that help strike a balance between generating income and managing risk, diversifying into ETF categories like cash, money market funds, senior floating rate bonds, and subordinated debt can help you manage your cash flow, even as term deposit rates look set to continue their decline.

This article was originally produced by Annabelle Dickson from Betashares. You can read the full article here.

Important information and disclaimer

The information provided in this document is general information only and does not constitute personal advice. It has been prepared without taking into account any of your individual objectives, financial solutions or needs. Before acting on this information you should consider its appropriateness, having regard to your own objectives, financial situation and needs. You should read the relevant Product Disclosure Statements and seek personal advice from a qualified financial adviser. From time to time we may send you informative updates and details of the range of services we can provide.

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