Term deposits rate highly when security is key

Money in term deposits has grown about $30 billion in the 12 months to May, according to research and ratings company Canstar Cannex. Over the past two years, term deposits have grown more than $50 billion.

To some extent, it's a flight to safety. In the post-GFC world, a guaranteed investment with a fixed rate of return has a lot going for it.

Canstar Cannex says Australian banks have also been using term deposit rates as lures, to attract deposits in the face of increased costs and an evaporation of foreign funding.

Rates of more than 6 per cent are available, with deposits up to $1 million guaranteed by the government.

With a growing number of investment platforms now offering term deposits as a superannuation option, many investors have found security combined with a known rate of return an option too attractive to pass up in this climate.

But, like anything else, term deposits are not foolproof.

One common source of complaints is that banks advertise attractive lead-in rates that don't apply when it is time to roll over into a new term deposit.

Let's say you sign up for XYZ Bank's advertised 6 per cent rate for six months. At the end of the six months, most investors will simply roll into another six-month term deposit. But in six months' time, your bank might not be offering a "special" on six-month deposits.

It may be offering just 4 or 5 per cent and may have moved its advertising to a new three- or nine-month "special". Unless you're on your toes and ask to be rolled over for a different term, you'll miss out on the best rate.

This is called dual pricing and, while frowned on by the Australian Securities and Investments Commission, it is still widely used by financial institutions. But this isn't the only trap that investors need to watch out for.

In its review of term deposits, Canstar Cannex also found some institutions require investors to open an associated savings account to access their term deposits, which can add to hassle and costs.

No doubt, it also provides a further deterrent for investors switching to another financial institution at the end of the term. The more accounts to close, the less attractive switching can seem.

Another point of difference is what happens if you want your money back before the end of the term for which you signed up. Most institutions will charge an interest "penalty" for early withdrawals, meaning you can lose much of your interest, while some don't allow early withdrawals at all. Canstar Cannex says you can "lose" up to 60 per cent of the advertised interest rate if you withdraw early.

While most of us don't plan on wanting our money back early when we sign up, circumstances can and do change and a lack of flexibility can come as a nasty shock.

While interest rates matter, Canstar Cannex found things such as how rollovers and early withdrawals are treated should also be considered when looking for an investment.

It says some institutions will offer a loyalty bonus of about 10 basis points when you roll over your deposit with them. This bonus usually applies when rolling over the same funds for the same term. The company it nominates as offering the overall best value on term deposits, ING Direct, offers bonuses on all funds rolled over to any terms for existing customers.

It says investors should also be prepared to negotiate a better deal when they want to roll over, particularly for sums of $100,000 or more. With competition for deposits still fierce, most institutions are prepared to offer a deal - even on smaller deposits.

But term deposits are not the be-all and end-all.

While they make a great safe haven, Tyndall Investments, in its latest fixed-income research, points out that, over time, term deposits tend to underperform both shares and bonds. It found that between 2002 and 2009, a portfolio of term deposits would have grown about 40 per cent, whereas bonds (measured by the UBSA Composite Bond All Maturities Index) would have grown more than 60 per cent and shares (measured by the S&P ASX200 Accumulation Index) would have grown more than 100 per cent - even after losses incurred in the GFC.

One of the risks with both term deposits and cash, Tyndall points out, is reinvestment risk. If rates fall, you will only be protected until your current term ends then you must reinvest at the new lower rate. With investments such as bonds, investors can realise capital gains by selling at a profit when rates fall.

But, as investors have found, you can also lose money with bonds if rates rise and you don't hold the bond until maturity.

Of course, managing a bond portfolio requires much more expertise - and money - than simply buying term deposits, which is why companies such as Tyndall offer bond or income funds as part of their managed investment portfolio. To justify the fees, a bond fund should provide better long-term returns than term deposits and a passive or indexed bond portfolio.