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Term deposits vs treasury bonds

I would like to apologize for the lack of new posts in the past few weeks as we were away for two weeks and last week I have been busy with getting the household back in order and helping the newest member of our family (a homestay student from China) settle in. I have also been trying to compile the performance of our SMSF investments for the last financial year for our accountant. Regular readers would already know that I have been generally bearish and have been trying out a few different bear market strategies last year. Some of our investment strategies have worked out better than others. My plan is to work out the performance of each strategy and update our investment strategy for the next financial year. I will then update Part 2 of our e-book which contains a copy of our SMSF’s investment strategy and write about our performance and some lessons learned last year on this blog. At the same time, the deadline for my monthly column for the Superliving magazine is fast approaching and I have decided to write about one of our bear market investment strategies that has worked out well last year. As this topic is part of what I planned to write on this blog, here are some excerpts from the article…

With the growing uncertainty in the global economy and increasing volatility in the stock market since the start of the year, many retail investors are increasing their allocation to the cash and fixed interest asset class. For retail investors, a popular investment in this asset class is to buy a term deposit from a bank. Australian banks have been offering term deposit interest rates of 6 percent or more which is a pretty attractive return. Bank deposits are generally considered “risk free” investments. However, we must not forget that a bank deposit is nothing more than an IOU from the bank so there is a risk of default if the bank goes bankrupt. This IOU is currently guaranteed by the Australian government so even if the bank you put your money with goes bust, you will still be able get your money back. However, after the government guarantee expires in October 2011, this IOU will only be guaranteed by the bank you place it with. Unlike the US, Australia does not have an equivalent of the Federal Deposit Insurance Corporation (FDIC) which provides a guarantee for all American bank depositors. Hence, for term deposits that expire beyond Oct 2011, it is important that you choose carefully which bank you deposit your money with, and you should not make your decision solely based on the yield offered.

Some of the smaller Australian banks have been offering very attractive rates but they may not be as safe as Big 4 Australian banks or highly rated international banks like Rabobank. Until recently, bank ratings were freely available to retail investors so you can have an idea of how safe a bank is, relative to another bank. However, in January 2010, ASIC in its wisdom has decided that bank ratings can only be disclosed to wholesale investors. Ubank (an online banking subsidiary of NAB) used to publish the rating of their competitor banks alongside the interest rate they offer on their website but the rating information is no longer available. Now retail investors can only find out the ratings for a bank through financial professionals who are deemed wholesale investors.

An alternative investment in this asset class would be government or treasury bonds. Just as term deposits are IOUs that are guaranteed by the bank you buy it from, treasury bonds are IOUs that are guaranteed by the government that issues them. In general, a treasury bond should be safer than a bank deposit as a country is less likely to go bankrupt than a bank. We have seen many banks, including mega banks like Lehman Brothers collapse overnight during the global financial crisis but with the recent debacle in Greece, we also realise that countries too can go bankrupt and default on their IOUs. Like banks, not all countries are equal so not all treasury bonds are equally safe. Rating agencies like S&P and Moody’s provide ratings for countries and treasury bonds from countries with low ratings tend to have higher yields compared to countries with higher ratings to compensate for the additional risk. US treasury bonds are recognised by global investors as the safest treasury bonds in the world and demand for them have been high especially with all the sovereign debt problems in Europe.

Treasury bonds are normally auctioned off in large blocks worth millions of dollars and buyers of these bonds are typically banks and institutional investors. It is hard for a retail investor to buy treasury bonds directly from the bond market. You can get exposure to treasury bonds through a mutual fund or super fund. My preferred way of buying US treasury bonds is to buy a bond exchange traded fund (ETF) as these can be bought and sold very easily just like stocks. Some of the popular bond ETFs are IEF (ishares Barclays 7-10 year treasury bonds) and TLT ((ishares Barclays 20+ year treasury bonds).

Treasury bonds have different investment risks and rewards compared with term deposits. While treasury bonds have a lower risk of default compared to term deposits, they have other risks. Unlike term deposits, the price of bonds can go up (or down) so you can make capital gains (or loss) from your bond investments in addition to the interest income. Demand for treasury bonds tend to go up when there is market uncertainty. Last year our SMSF made an investment in IEF, the ETF for 7-10 year US treasury bonds. As you can see from the chart below, prices have shot up since April 2010 when the stock market started to tumble. This investment has provided our fund with a nice capital gain of about 7 percent and interest income of over 3 percent last year. For income investors, another nice feature of this investment is that interest is paid in the form of a monthly dividend.

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