Climbing the Term Deposit Ladder

 

About a quarter of SMSF assets are invested in Australian bank deposits (i.e. deposits).

Deposits are often held passively while fulfilling liquidity needs or as defensive assets for managing risk in uncertain times. Earnings maximisation might not receive the attention it deserves or be overlooked all together.

Seeking the highest earnings can be rationally justified given the similarities in Australian bank risks.

Diagram 1.0 Sample SMSF Portfolio Structure (The proportions are for demonstrating purposes only)


The above diagram prompts the reader to consider the purposes of their funds. Funds are required to meet budgeted expenses and some funds are kept at call just in case instant liquidity is needed for unexpected expenditure or investment opportunities (1).

The rest should be made to work as hard as possible (2).

Thinking Rationally

A lower rate is acceptable if risk is reduced, safety increased (4) or some other benefit supplied in return. Deposits pay a lower interest rate in return for security and liquidity, i.e. easy certain access to money either at call, or at a set time in the future if the commitment is a term deposit.

Investing in the highest return is the rational action to take when deposit risks are similar.

Term Deposit Yield Curve

Term deposit yield curve, is the terminology used to describe a series of term deposit rates at different maturities ranging from ‘at call’ to five years.

It is often represented graphically with month or years on the horizontal axis and the interest rate (i.e. yield) on the vertical access.

Diversification across a variety of term deposit maturities is a strategy that can boost returns over a chosen period. This might necessitate investing in a variety of banks to achieve the best return for each given term (6).

Each bank has its own term deposit yield curve and the challenge is to find the bank with the optimal rate for each preferred term, subject to the SMSF’s liquidity requirements for that period.

Fintech innovation has made this once frustrating task easy.

Yield Curves Come in Many Shapes and Sizes

Longer investment terms generally pay higher interest rates.  This is usually displayed as a positive yield curve.

In practice, yield curves can take on a variety of shapes. For example, some economic conditions can give rise to shorter-term rates that are higher than the longer-term equivalent; market professionals call this a negative yield curve.

This blog only considers the positive yield curve.  Other types of yield curves will be considered in later Blogs.

Reward for stability

Consider the other side of the transaction.

Banks should be prepared to pay more because the funds can be put to a bigger variety of uses knowing the availability is certain.

The task of finding new deposits is costly, so the bank values their longevity. Raising funds in wholesale offshore markets is also costly, even more so when it is most needed.

Managing bank liquidity is easier when term deposits are committed for longer. Regulators prefer banks to have longer term funding because it fosters stability in the financial system.

Put excess SMSF liquidity to work

The confluence of SMSF trustees demanding higher rates for longer-term commitments and banks benefiting from the stable use of funds creates the conditions for a positive yield curve; a win/win situation!

Responsible SMSF trustees will expect an equal or greater return for the benefits longer dated deposits bring to a bank.

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Reference
1. SUPERANNUATION INDUSTRY (SUPERVISION) ACT 1993 – Section 52 (2) (i) & (6) (iii).

2. SUPERANNUATION INDUSTRY (SUPERVISION) ACT 1993 – Section 52 (6), (7), & (8).
3. Risk can be defined as the possibility of an undesirable outcome such as earning less than expected, losing capital, or not having access to capital when it is due.
Insurance protection or additional collateral for example.
4.SMSF trustees should consider their obligations under SUPERANNUATION INDUSTRY (SUPERVISION) ACT 1993 – Section 52 (6) (ii).

 

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