3 reasons why bonds make more sense than term deposits today

Volatile markets and rising interest rates have led to major asset allocation shifts over the past year. Many investors have built significant cash buffers to prepare for an impending downturn, parking their money in term deposits until they are ready to invest.

In our view, however, increasing cash buffers by investing in term deposits is not enough to achieve a truly efficient portfolio outcome. We believe investors should also consider bonds, particularly in an environment where we may be seeing interest rates hit their peak.

Here are three reasons why allocating to term deposits may lead to missed investment opportunities compared with bonds.

#1 - Exiting term deposits early can be costly.

Unlike bond funds that offer daily liquidity, term deposits lock up money for a fixed period of time and require investors to make a “term” decision regarding their access and the interest rate earned. If you identify an attractive investment and want to withdraw your funds early, you may have to pay a penalty fee and only receive a proportion of the interest, or none at all. The cost may be around 25% of the income generated and so is something investors should consider.

#2 - Term deposits entail reinvestment risk as well as lack of flexibility when you need it.

Once the term deposit ends, reinvestment risk should be a consideration. With market pricing indicating that we are nearing the cash rate peak, there is a risk that interest rates will be lower in a year’s time. As such, you would have to reinvest at a lower interest rate than the current rate when the term deposit ends. Meanwhile, by locking up money for a 12-month term, you could miss out on the chance of investing in other assets when valuations are attractive. For those parking their money until they are ready to invest, this could entail missing out on potential opportunities.

#3 - Term deposits don’t offer the same diversification and capital appreciation potential as bonds.

Locking in a fixed-term deposit means forgoing the defensive attributes that bonds deliver in an environment of declining interest rates, such as in the event of an economic slump. Bonds prices typically appreciate as economies enter recession, which would help offset losses likely experienced in other parts of a portfolio – namely equities (as earnings decline) and real estate (as home prices depreciate) – making bonds a crucial element of a balanced portfolio. As Figure 1 shows, given today’s higher starting yields, bonds should offer strong downside protection if an economic downturn forces the Reserve Bank of Australia to start cutting interest rates.

Figure 1: Bonds would offer greater downside protection than term deposits in a downturn. This bar chart shows PIMCO’s scenario analysis of the effect of interest rate changes on bond returns. It shows the estimated total return for the 10-year Australian government bond over the next three months if risk factor shocks were to happen today. If interest rates were to fall 100 basis points, we would estimate a 6.1% return, while a fall of 50 and 25 basis points would return 3.5% and 2.3%, respectively. Conversely, if rates were to rise by 25 basis points, we estimate a return of -0.1%, -1.3% for a 50 basis point rise and -3.5% for a 100 basis point rise. The data source is PIMCO as of 30 August 2023 and it is a hypothetical example for illustrative purposes only.

Bond market valuations appear attractive as we near the cash rate peak

After significant repricing in 2022, bonds now offer investors the chance of earning the highest real yields in a decade as we approach the peak of the monetary policy cycle. At the same time, the market is signaling that a downturn is coming, reinforcing the case for holding bonds due to their defensive properties.

Bond market pricing shows that market participants expect short-term bond yields (on securities maturing in less than one year) to rise meaningfully, medium-term bond yields to move only slightly higher, and 30-year yields to fall. This creates an inverted bond yield curve — a downward-trending or “inverted” yield curve has historically signaled a recession (see Figure 2).

Figure 2: Inverted yield curves in Australia and the U.S. suggest tough times ahead. This line chart shows Australia on the left and the US on the right hand side. Each has 2 lines showing bond yields in percentage terms – one line representing January 2023 and the other August 2023. It indicates that across the yield curve from 1-month maturities to 50-year maturities, bond yields are substantially higher in August 2023 vs January. In addition it shows an inverted yield curve in both jurisdictions, albeit more pronounced in the US. The data sources are PIMCO and Bloomberg as of 31 August 2023.

In our view, investors should not only take advantage of the higher bond yields on offer today, but also consider how to build resilient portfolios to withstand this potential economic downturn.

Now is the time to bolster portfolios with bonds

Loss aversion and herding behaviour can lead investors to hold excess cash even when fundamentals are not favourableFootnote1. Both of these biases can lead investors to allocate to term deposits instead of investing in bonds, even if it is not the best decision to meet their investment goals.

The most effective way for Australian investors to mitigate market uncertainty is to ensure they balance the growth assets in their portfolio with defensive assets such as bonds, since bonds should outperform in a risk-off scenario when equities and other risk assets decline. While term deposits may seem like a safe and stable option, bond funds can offer daily liquidity, greater diversification from equities and real estate, and the potential for better long-term outcomes in terms of income and capital appreciation.

Managed Fund

PIMCO Diversified Fixed Interest Fund

Australian Fixed Income

View