In the discussion of investment options we often focus on shares and residential property - the higher risk, higher return investment options. We often don't talk about cash and term deposit style investments, although they have a crucial role in any investment portfolio.
As interest rates rise the media focuses on the difficulties being experienced by people struggling to service mortgages. However, there are a group of people who benefit from interest rate rises - those people who have money invested in cash accounts and term deposits. For these people an increase in interest rates means an increase in income.
At the moment cash rates are stronger than they have been in more than a decade. This is partly because of the rise in interest rates, and partly because of the 'credit crunch' that is happening in world investment markets. The 'credit crunch' means that many banks are having trouble borrowing money as easily as they have been in the past. Because of this the money that banks and financial institutions get from individual investors has suddenly become more important, and they are prepared to offer higher rates of interest to get it.
Another change in the 'cash account' landscape has been the rise of 'e-accounts'. These are simple bank accounts, supported by online or phone access which often have limited access (usually you can only withdraw money to one other nominated account) with the upside of no fees and high interest. These often pay the high interest on low balances, although you should check this carefully before investing.
What Rates are Available?
A quick check of the accounts on offer through major banks show that many e-accounts offer interest rates of 6.5%, and term deposits with 12 months terms are available paying interest rates of 7.5% to 8%. These are strong returns for investors, and as good as they have been at any time over the past 10 years.
The Strategic Use of Cash/Fixed Interest Investments
It is important to understand the role of cash and fixed interest style investments within a portfolio and in planning your overall financial strategy.
Cash can be considered as an almost 'risk free' investment. The return is less that you would receive in the long run from investing in shares or property; however the return is much more reliable. That is, when you put money into a cash account you know that it will not fall in value like shares or property might.
Cash and fixed interest investments fulfill the role of:
Providing easy access to cash (liquidity) - this is the role of a 'cash reserve'. By putting some money into a cash account you know that it can be very easily accessed at any time that you need it - for example in an emergency.
Reducing the volatility of a portfolio - cash investments are not volatile like sharemarket or property investments. By having some of your portfolio in cash you reduce the overall volatility of a portfolio.
Allowing you to plan your income needs. If a person is retired they may want to keep a number of years of income in cash. That way, regardless of portfolio volatility they know that a number of years of income are set aside. For example, a person drawing $10,000 a year from a $100,000 portfolio might keep $40,000 of their portfolio in cash so that they know that they have 4 years of income needs set aside in the low risk environment of cash.
How Do You Know if High Interest Accounts Are Safe?
Many investors have lost a total of hundreds of millions of dollars in failed investment schemes like Westpoint and Fincorp. A reasonable question is how does an investor differentiate between these relatively high risk schemes and much safer term deposits or bank accounts?
The key is the role of APRA. They are the regulator of the banking sector, and monitor the 'authorised deposit taking institutions'. They publish and up to date list of these institutions on their website (http://www.apra.gov.au/).
Westpoint and Fincorp were not authorised deposit taking institutions, and their risk profile was much higher than authorised deposit taking institutions that are overseen by APRA.
I contacted APRA to find out about the loss from deposits associated with authorised deposit taking institutions. I was informed that there had been no recent cases of losses and the last bank loss was in 1931 when the Primary Producers Bank had depositors that lost 1.25% of the value of their deposits when the bank went into liquidation.
Cash is an important part of any portfolio and financial planning strategy. With increasing interest rates and financial institutions competing harder for your money that for some time, returns from this asset class will also be strong in at least the short term.