Income investing: To fix or float?

Background

At an annualised 1.6% p.a., the most recent consumer price index (CPI) was surprisingly low, prompting the Reserve Bank (RBA) to announce a 50bp (0.5%) cut to the official cash rate. Those reliant on income from term deposits (or similar) are understandably spooked.

So, is it time to be rolling into a five-year term deposit or looking at even longer dated fixed income securities?

Had one asked that question a few years ago, the answer would have been a more confident ‘yes’. Term deposit fans may recall Westpac’s very attractive 8% for five years special offer.

Back then, single digit interest rates seemed completely out of step with an economy saddled with high levels of mortgage debt and heavily reliant on a mining boom and government stimulus.

It was difficult to see interest rates rising much further without wreaking economic havoc so there were less downside (and a lot of upside) to fixing.

That’s no longer the case. The RBA cash rate is approaching its historical low of 3% and the highest five-year term deposit rates are stuck at 6% p.a.

If you have no fixed interest investments, then locking in a portion at the current rate makes some sense. Especially if you think there is a fairly low risk of an inflation outbreak.

Nevertheless, there’s a catch for those that do decide to act. Lock in too much or for too long and you leave yourself exposed to inflation and increases in long term interest rates, and deny yourself the natural advantages accruing to the cashed up.

What should one do?

Natural advantages

Income investors (or those holding a high proportion of liquid assets) have some key advantages right now:

1. The RBA works for you. Using interest rates as its primary weapon against inflation, the RBA effectively works to earn income investors a decent ‘real rate of return’ (see later).
2. The world is deleveraging. Inflation is always a possibility, but we live in a globally connected, deleveraging world. That’s a more likely backdrop to deflation than inflation, although no-one can predict the future. Interest rates fall in a deflationary environment while assets reliant on leverage, like property, tend to fall in price more rapidly. An income investor’s advantage is that they’re a potential buyer of last resort when highly leveraged investors are selling. You may be happy to lock in rates of up to 6% p.a. for 5-10 years but wouldn’t having the cash available to pick up discounted assets offering attractive yields be even better?
3. Liquidity is at a premium. Another consequence of a deleveraging world is that borrowers are forced to pay a premium to borrow long term. Australian banks, for instance, have to pay through the nose to lengthen the maturity of their funding. Income investors have benefited with attractive term deposit rates, a process unlikely to abate.

This is not to say fixing is a bad idea. Indeed, we’d suggest that if you haven’t already got a portion of fixed interest in your portfolio (either long dated term deposits or fixed interest securities) then it might be worthwhile ‘locking in’ a portion now for peace of mind.

But unless you are a devout believer in deflation and confident you can pick the timing of the subsequent asset bargain sale, don’t be too quick to throw away the natural advantages of holding easily-accessible cash. Besides, if you rate deflation a chance, remember that a serious bout of deflation could decimate our banks balance sheets. You may benefit from having fixed interest rates but this might not be the time to have your cash locked up.

Let’s now consider this and other issues in more detail.

Inflation and CPI

Inflation is the bogeyman of the income investor (and holders of financial assets generally) and the number one thing you should be worried about. At the very least, you need to preserve the purchasing power of your capital.

The fact that, for now at least, the inflation genie is very much trapped in a bottle should be a cause for some relief. On the other hand, deflation, at least in a mild sense, is your ally.

In a deflationary environment (negative CPI) the RBA loses its ability to reduce ‘real interest rates’ because rates can’t fall below zero and borrowers (including the banks) still need to pay decent margins to raise money. Monetary policy ends up far tighter than the RBA would like it to be, which isn’t great for the economy but is a win for income investors.

Today, if you take advantage of Rabo Direct’s five-year term deposit at 6%, you would be earning a real rate of interest of 4.4%pa (6% minus 1.6% CPI). But if we experienced a CPI of, say, minus 3% p.a. – and Rabo still need to pay 2%pa to attract funds – then your real rate of interest will have increased to 5%pa.

Under these circumstances, your purchasing power has improved, and possibly dramatically so. And you didn’t need to over-expose yourself to inflation to achieve it.

Australian dollar considerations

There’s another consideration. Lower interest rates may bring about a reversal in the Australian dollar (AUD), a fact that income investors need to consider:

1. A weaker AUD will help the earnings of exporters and increase the AUD value of foreign assets. This is likely to have a positive impact on the shares you own, for example, offsetting the impact of lower rates on your term deposit income.
2. Australian banks have been extremely reliant on foreign borrowings to fund their expanding balance sheets. This spreadsheet contains the RBA data on ‘Monetary Aggregrates’. This shows that, in the aftermath of the GFC in October 2008, offshore borrowings dipped to $231b. With the wholesale Government Guarantee in place they were able to increase this to $345b (October 2010). Foreign borrowings are now much lower ($308b at last count). The pace of this move could accelerate with falling local interest rates and a declining AUD.

What does a reduction in foreign borrowings mean for you?

Firstly, the bank funding hole will need to be plugged. The Monetary Aggregates data shows that the banks have turned to depositors in a big way since October 2008 (term deposits are up almost $200b) and this is likely to continue if foreign lenders depart. Whilst the RBA may be pushing down the cash rate, banks are likely to continue to offer attractive deposit rates.

Secondly, the banks are still expanding their balance sheets. The RBA data on Lending and Credit Aggregates shows that overall credit growth continues. Were that to slow, stop, or decline, it would play havoc with the values of bank assets, especially residential property loans.

The incentive to keep balance sheets from shrinking, combined with the reduction in foreign borrowing, means banks will need to work hard to attract depositor cash. Any large scale move by depositors into the sharemarket will only add to that pressure.

Remember that interest rates paid by the banks (on both term deposits and wholesale funding) are a mixture of ‘base interest rate’ and ‘margin’. The RBA are pushing short term rates lower but there is plenty of upward pressure being applied to margins. There is no guarantee that longer term rates are going to move substantially lower.

Diversification opportunities

If a large proportion of your assets are in term deposits and Australian debt securities, then you’re heavily exposed to one asset class—the Australian dollar.

For income investors, holding some non-AUD assets—international equities, currencies, bonds, commodities and precious metals—therefore makes sense, especially if, in a falling interest rate environment, the AUD comes under selling pressure. Exchange gains on non-AUD assets can then compensate for falling rates of interest.

Take note that commodities and precious metals have run up significantly in price (in both foreign currency and AUD terms) in recent years. International equities, on the other hand, haven’t moved much in AUD terms. Chart 1 shows the movement in the S&P 500 when denominated in AUD.

Remember the backdrop to falling interest rates is likely to be declining asset prices, with property (residential and commercial) especially exposed. Investors with cash may benefit from higher interest rates, as the banks are forced to pay through the nose for funding, or by having the opportunity to buy, as property prices fall more rapidly than rents, producing attractive rental yields.

This isn’t to predict an imminent house price crash. Holding cash, however, offers an ‘each way’ bet not to be given up too readily in favour of locking in term deposit rates now.

The danger of locking in for too long

If you’re considering fixed interest securities with terms of 10 years or more, take extra caution. The recent past shows how the world has become extremely volatile and unpredictable.

As Chart 2 shows, Italian savers that locked in to long term fixed rate Italian bonds (to avoid falling interest rates post-GFC) learnt that the hard way.

Italian short term rates are now much lower but the increase in long term bond yields has seen these investors make losses despite the fall in short term rates. In Spain, it’s even worse. Those that invested in Spanish 15-year bonds in 2008 have suffered significant capital losses.

Australia is neither Italy nor Spain but such events are a reminder that things can change dramatically over the long term, and especially when you are a debtor nation. The RBA may work to keep short term rates low but it has much less control over long term rates.

Action summary

Let’s summarise:

• If you are heavily reliant on income from term deposits, consider longer term fixed rates (if you haven’t already) for peace of mind. Just don’t get too carried away—there’s a potential cost to not holding enough cash;
• Holding non-AUD assets—international equities, currencies, bonds, commodities and precious metals—offer diversification benefits. Consider buying some but note the heavy run up in price of commodities and precious metals in recent years;
• If deflation takes hold, your real rate of return is likely to be preserved (or even improved) at a time of possibly very attractive investment opportunities. That’s another reason not to lock your cash up too tightly.