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Credit Crunch's Silver Lining - Eureka Report article

June 18, 2008
Credit crunch's silver lining
By Scott Francis

PORTFOLIO POINT: Fixed interest investments offering strong returns provide a defensive core to a portfolio. But watch managers' fees and tax implications.

At first glance the "subprime crisis", which turned into a broader "credit crunch', would seem to have been all bad news for investors. Stockmarkets have fallen about 20% and the value of listed property trust investments have fallen by more than 30% over the past nine months.

The debt crisis has made it more expensive for banks to borrow money, and they are turning to retail investors (that's pretty much all of us) with attractive offers if we are prepared to lend them our money.

Term deposits play an important part in the Australian investment landscape. It is difficult for investors to make investments directly into government or corporate bonds because they often have a "face value" (investment amount) of $500,000 each. There are some listed fixed interest investments on the ASX, such as the Suncorp notes, which listed on Friday at a slight discount to their $100 face value and can be accessed directly by investors. Others include notes issued by ANZ, Fairfax and Seven Network.

Many investors use managed funds to access fixed interest investments. This has the advantage of providing diversification for investors, but the fees can be a problem. A 1% fund manager fee on an asset class returning about 7.5% equates to 13% of the return given up. Many fund managers have fees well over 1%, making it difficult for investors to receive a fair rate of return after fees.

Which brings us to term deposits - bank and credit union issued fixed interest investments that investors can access directly.

Westpac, for example, is currently offering a term deposit rate of 8.1% over 12 months for $10,000 or more. The question we look at is: which factors should investors consider in deciding if this is a good investment option for them?

The nuts and bolts of a term deposit

Most term deposits simply calculate the interest and pay it at maturity. A $10,000 term deposit with Westpac would see $810 paid in interest at the end of 12 months.

I have noticed an increase in the number of term deposits that pay interest on a regular basis throughout a term; monthly, for example. Cannex lists the Commonwealth Bank as having a 12-month term deposit paying 7.8% interest. Because the interest is paid monthly, there is a compounding effect in that each monthly payment can be invested to earn slightly more interest. The "nominal" interest rate for this investment is quoted as 8.08%, which is the interest rate if there was just one simply interest payment at the end of the 12-month period. The 8.08% nominal rate would be the correct rate to compare to the 8.1% received from the Westpac term deposit.

Term deposits are specifically regulated by the Australian Prudential Regulation Authority, which enforces prudential standards to protect depositors. Standard & Poor's is a worldwide credit rating agency that makes assessments of the credit quality of financial institutions. Although it has been criticised for mistakes made on rating "collateralised debt obligations" of recent times, it is still seen as a key source of investor information as to the credit worthiness of institutions. S&P's benchmark ratings scale, with definitions sourced from its own website are:

AAA The obligor's capacity to meet its financial commitment on the obligation is extremely strong. Australian government bonds have a AAA credit rating. Rabobank Australia also has a AAA rating, higher than any of the Big Four Australian banks.

AA The obligor's capacity to meet its financial commitment on the obligation is very strong. The Big Four Australian banks have AA credit ratings, including Westpac as issuer of the $10,000 term deposit discussed in this article.

A An obligation rated A is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than obligations in higher-rated categories. However, the obligor's capacity to meet its financial commitment on the obligation is still strong. St George Bank has an A+ credit rating,

BBB An obligation rated BBB exhibits adequate protection parameters. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the obligor to meet its financial commitment on the obligation. The Bank of Queensland has a BBB+ credit rating.

BB, B, CCC, CC, and C These are considered 'below investment grade' and are regarded as having significant speculative characteristics. 'BB' indicates the least degree of speculation and 'C' the highest. These are sometimes known as 'junk bonds'.

D An obligation rated D is in default of its payments.

Investors can use these ratings to help make decisions about term deposit and bank deposit investments. For example, if both Westpac (rated AA) and a BBB-rated bank were offering term deposit rates of 8.1%, an investor would be wise, from a prudential point of view, to choose the bank with the higher credit rating.

A risk of term deposits: rising interest rates

One of the risks of taking a term deposit over a long term is that if interest rates rise during the term, you are locked into the interest rate. For example, investors who three years ago locked in a term deposit rate around 5.5% would be missing out on the higher interest rates on offer at the moment.

Institutional risk and diversification

A key risk of a investing all of your money with one institution is that the institution will collapse. While we are lucky in Australia, with a reliable and well regulated banking sector, it costs nothing to diversify your risk. If you have $100,000 in a term deposit with one institution earning 8.1%, or four $25,000 term deposits with four institutions earning 8.1% (excluding fees), your return is exactly the same, but you have spread the risk over a number of institutions. It is not too hard to diversify a term deposit investment, with most shopping malls offering a number of bank options and many term deposits being able to be set up online.

A taxing problem

A key downside of any cash or term deposit investment is that 100% of the investment return is taxable. This is best demonstrated by looking at the recent ASX/Russell Long Term Investment Returns report. According to the survey, over the past 20 years an investor in the sharemarket at the highest rate of tax lost 17.6% of their return to tax; an investor in listed property trusts 27.4% of their return to tax and an investor in a cash investment lost 50% of their returns to tax. Australian shares and listed property trusts are more tax-effective because some of their returns are from capital gains, which are not taxed until they are sold and may be taxed at a reduced capital gains tax rate if the investments have been held for 12 months. Australian share income has the tax benefit of franking credits. Australian listed property income has the benefit of some tax deferred or tax-free income.

The following table summarises the results of this survey:

nThe tax effect
Average annual pre-tax return Return at super fund tax rate and % reduction in return Return at highest marginal income tax rate and % reduction in return
Australian shares 12.5% 12.9% - a 3.2% increase in return 10.3% - a 17.6% decrease in return
Cash 6.4% 5.5% - a 14.1% decrease in return *3.2% - a 50% decrease in return
Australian listed property 12.4% 11.3% - an 8.9% decrease in return 9.0% - a 27.4% decrease in return
* The top tax rate over the time of the survey was generally 48.5%. Therefore, I assume that there is small amount of
rounding in either the 6.4% figure or the 3.2% figure that sees an exact 50% decrease in return dues to tax.

I still favor a well diversified portfolio of high credit quality fixed interest investments as the core of any fixed interest asset class within a portfolio. The best way to achieve this in the Australian environment at the moment is through some form of managed fund. Even though fund manager fees might eat into some of the returns (and therefore should be kept as low as possible: preferably 0.75% or less), the fixed interest and cash parts of the portfolio should be the "lowest risk" part of a portfolio and diversification is part of managing that risk.

That said, some high credit quality term deposits around this well diversified core of investments makes sense, particularly in an environment where banks are willing to pay attractive interest rates for the use of our money.