Invest in a corporate bond fund or put your money in a term deposit? It’s a question more pertinent now than ever, as market interest rates push towards new lows.
Both term deposits and managed bond funds are suitable for investors who want a reliable income stream, liquidity and capital preservation. But they have different risk and reward outlooks. We consider each in detail below.
Corporate bond funds
Corporate bond funds can provide an attractive, low-risk alternative for investors seeking a reliable, consistent income stream with returns typically higher than cash, while also providing investors with a return stream which has historically protected against falling equity prices.
They typically suit investors with a longer-term investment horizon willing to take on slightly more risk.
A corporate bond fund will typically generate income above cash and term-deposit levels, as owning the bonds issued by banks and corporates earns investors an additional premium over cash to compensate for the additional risk of not being repaid. It may be structured to have sensitivity to changes in interest rates (typically measured as ‘duration’), and so the returns earned by owning units in a fund may be impacted by this.
An actively-managed corporate bond fund may provide additional returns to investors by increasing or decreasing the sensitivity to credit spreads and interest rates based on the manager’s views on whether these markets are over or under-pricing the associated risks. This may mean changing exposures to certain sectors like banks, utilities or telecommunications, and by focusing investments in key issuers that are expected to improve in credit quality.
An actively-managed corporate bond fund may also reduce the sensitivity to changes in interest rates by managing the duration of the fund. If the portfolio manager’s expectation of future changes in interest rates differs from that of the market, then they may choose to position the portfolio to potentially profit from this. For instance, if the portfolio manager expects yields to rise by more than the market is currently pricing, then they may choose to reduce the fund’s sensitivity to higher yields (which cause bond prices to fall). Conversely, if the expectation is for interest rates to fall, the portfolio manager may choose to increase the fund’s sensitivity to interest rates, to benefit from falling bond yields (which lead to higher bond prices).
Bonds can help reduce risk within an investment portfolio by providing a buffer in times of market stress. They provide a diversification benefit to an investor’s overall portfolio and historically, bond returns have been negatively correlated with riskier assets such as equities. This has meant that bond prices have usually risen in value when share prices are falling (and vice versa).
Most investment-grade corporate bond funds publish unit prices every day, unlike term deposits which do not. This provides the appearance that there is greater volatility in the unit price of a bond fund, relative to cash or term deposits. However, an investor with a longer-term investment horizon should achieve better returns over time when compared with a term deposit or an exposure to cash.
Term deposits are popular with investors wanting security in the return that they will receive over a period of time, and certainty that their capital will be returned at this time. They are a good option for those with investment horizons of less than 12 months, provided that investors do not wish to access their investment before the end of the term, as additional fees can apply for early access.
Term deposits typically generate a higher rate of return for an investor compared to leaving their money in a transaction account. Investors in term deposits also benefit from the government guarantee on deposits (which protects deposits up to $250,000), which can provide comfort to an investor if the viability of the bank the term deposit is with were to ever come into question.
Investors also need to be aware that term deposits come with their own set of risks. Primary amongst these is the risk for investors that when they come to roll their investment at maturity, the interest rate may have fallen. This is called re-investment risk. In recent years, the returns offered on term deposits have been relatively stable, and re-investment risk has not been an issue. This is because the market’s expectation for the future path of interest rates has been reasonably stable. However, sustained falls in bond yields may mean banks choose to offer lower term deposit rates in future periods, as those banks may be able to finance themselves at better interest rates elsewhere. This can have a substantial impact on the returns generated from a term deposit roll-over strategy, if subsequent term deposit rates materially fall.
Ready access to a term deposit is also restricted through the term of the contract. If an investor requires access to their funds – for whatever reason – this can take up to 31 days from the date of request. The issuing bank will also usually charge an “interest adjustment”, which is a penalty charge for breaking the conditions of the term deposit prior to maturity and may reflect a combination of fees and forgone interest.
Investors in an actively-managed corporate bond fund may reap the benefits of combining a portfolio of bonds to achieve a stable, diversified income stream to longer-term investors during different market cycles. A skilled active bond manager may deliver above-average returns through the market and interest rate cycle while lowering overall portfolio risk. Term deposits also remain a viable investment strategy for shorter-term investors, depending on their role within a broader portfolio allocation, though investors need to be mindful of the risks.
Corporate bond funds
Typical investor type
Deposits up to $250,000 are guaranteed by government
Guaranteed interest rate
Higher rate of return than a transaction account
Investment value changes alongside yields
Volatility in daily price movements
Higher level of risk compared to term deposits
Illiquid asset; normally need 31 days’ notice to access funds
Penalties may apply for accessing money early
Reinvestment risk if yields fall
Please call us on 1300 181 707 if you would like to discuss.
Author: Nathan Boon, Sydney, Australia
Source: AMP Capital 11 April 2019
Important notes: While every care has been taken in the preparation of this article, AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232497) and AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMP Capital) makes no representations or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. Past performance is not a reliable indicator of future performance. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. An investor should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to the investor’s objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.