Where to park your million now?

PORTFOLIO POINT: The deposit guarantee is being reduced, but investors still have plenty of options.

The Gillard government recently announced the guarantee on deposits would be reduced to $250,000 – down from the $1 million level the Rudd government had extended in the depths of the global financial crisis back in October 2008.

The change to the guarantee – officially called the Financial Claims Scheme or FCS – will reduce competition between the big four banks and their smaller competitors; the regional banks and the mutuals (credit societies and building societies).

Deposits larger than the cap are likely to drift back to the big four given their much higher credit quality. The big banks will rightly capitalise on the move and as a consequence we expect term deposit rates for more than $250,000 to fall in coming months.

However, there are strategies available to retain the government guarantee and/or the higher rates of return. This article will detail the facts about the scheme then explore options available to investors under the new lower guarantee limit.

The facts

From February 1, 2012, the new deposit guarantee “permanent cap” will be $250,000 and will continue to apply per person per Authorised Deposit-taking Institution (ADI).

The FCS has been confirmed as a permanent feature of the Australian banking system. This was announced in the government’s banking competition package released back in December 2010.

In October 2008 the government brought in the automatic deposit guarantee capped at $1 million. The guarantee was set to expire on October 11, 2011. In the same announcement, the government has extended the $1 million limit until January 11, 2012.

However, there was one transitional concession provided in the announcement. Term deposits already in existence as at September 10, 2011, will continue to be covered up to $1 million until the earlier of the scheduled maturity date or December 31, 2012.

Accordingly, the following guarantee cap applies to the various scenarios:

• New or existing deposits that mature on or before January 31, 2012, will continue to be guaranteed up to $1 million.
• Existing deposits that have a scheduled maturity after January 31, 2012, will receive transitional relief and are covered up to $1 million until the earlier of the scheduled maturity date or December 31, 2012. Such deposits must have been entered into on or prior to September 10, 2011, and investors will not be able to roll over term deposits that mature prior to January 31, 2012, to avail themselves of the transitional relief.
• New deposits made from September 11, 2011, onwards that mature after January 31, 2012, will be guaranteed to $1 million until January 31, 2012, and then revert to the new cap of $250,000 from February 1, 2012.

The government also announced some minor legislative changes it intends to make to the FCS framework. In essence it will remove the deposit guarantee for deposits made by foreign branches of Australian-incorporated ADIs. The charter of the Banking Act and APRA is to protect Australian depositors (and hence not foreign depositors in Australian ADIs offshore).

There will also be some amendments to improve flexibility for operating the FCS in the unlikely event an ADI is expected to fail. APRA will have the ability to transfer deposits to a new institution and the Treasurer will be able to activate the FCS before an ADI has formally reached the point of winding-up.

So what are my options?

A government-guaranteed term deposit is still an excellent investment. The guarantee gives the investor the same protection as those investing in Commonwealth government bonds, which are considered “risk-free” as the government has the ability to raise taxes and print money. So, in Australian market terms, a Commonwealth government bond and a guaranteed term deposit are the lowest-risk investments you can own. The difference between the Commonwealth government bonds and government-guaranteed term deposits is liquidity. The bonds are highly liquid and that means they are easily traded. A term deposit locks the investor into a set investment period, so investors should be rewarded for that loss of liquidity.

At the moment you can earn more than 100 basis points (bps) or 1% over the bank bill swap rate (BBSW) for a $250,000 one year term deposit. The best rate on offer from Termdeposit.com.au was 5.75% from a regional bank. However, one of the major banks was offering a high 5.60% or 148bps over today’s one year BBSW rate of 4.12%.

Option 1
If you have more than $250,000 to invest, you could split your investment between institutions. Termdeposit.com.au lists the details of some 60 ADIs, all of whom provide access to the $250,000 government guarantee. If you were to deposit $250,000 with each one of them you could potentially invest $15 million and have the total sum government guaranteed.

The downside to this strategy is that if you lock in your funds and can’t access them without incurring a break fee. But you can invest the funds for different terms to suit your cash flow needs. Remember that shorter investment periods will pay lower returns.

Option 2
Do some research, or find a third party that will do the research for you and make a risk assessment of the ADI. Key measures you’ll need to assess are:

• Size.
• Geographical diversity.
• Profitability.
• Loan book or business risks of the ADI.
• Deposits to loan ratio.

The funny thing about the guarantee is that it has been implied but not explicit in Australia for years. Most of the time what has happened to financial institutions in Australia that have got into difficulty (and we can’t actually be certain they have had troubles) is that APRA, or the relevant financial regulator, has orchestrated a takeover (in the case of Pyramid Building Society, depositors were eventually bailed out to the tune of $900 million although it was a different story for creditors and holders of redeemable preference shares).

The point I’m making here is that the guarantee provides us with a degree of certainty that already exists implicitly. I think the possibility of a depositor losing money in Australia is remote, but it does exist. As an investor, if you want to invest more than $250,000 in a single financial institution, you’ll need to make a risk/reward assessment.

The big four banks are low risk as they are diversified, have significant assets on their balance sheet, and are consistently profitable. The low-risk nature of the institutions means they can pay lower rates to attract deposits. Higher risk, smaller competitors will need to pay more to attract deposits. But if you are comfortable that they aren’t going to go into liquidation then you can potentially pick up a higher return.

If you also think the risk of loss is minuscule, you’d opt to deposit your funds with the institution paying the highest rates.

Option 3

Consider putting part of your cash into bonds for added return. By investing lower in the capital structure in those well-known banks where you are confident that they will continue to trade, you can pick up an additional return. While senior bonds are higher risk than term deposits, the main benefit they have is that they are liquid. Typically, you can sell at short notice without loss.

Yields on Australian dollar bonds continue to contract as market expectations for a low growth economy become more widespread. Some of the bonds you might consider are the Westpac fixed rate bond maturing in February 2020, which currently has a yield to maturity of 6.30%. Although this bond is long dated it is liquid. Should market perceptions about interest rates continue to contract, this bond’s price will rise, providing investors with the possibility of a capital gain (remember you can also incur a loss if you need to sell prior to maturity).

The other bond I’d consider is one issued by National Wealth Management, a subsidiary of National Australia Bank. This bond is subordinated debt, so sits under senior debt and for that reason is higher risk. It has a June 2016 maturity date and is also has a fixed coupon. But it has a current yield to maturity of 7%, the required return to double your money in ten years (click here).

For investors prepared to consider foreign bank issuers, the yields are higher than those offered by domestic issuers. Australian dollar issued senior debt is yielding over 7% to maturity and some subordinated debt issues are paying close to 10%.

Elizabeth Moran is director of fixed income research at FIIG Securities.