Alternatives to Term Deposits
With the Reserve Bank of Australia (RBA) signalling potential interest rate reductions over the coming years, investors reliant on term deposits and cash for income face a challenging environment. As banks typically offer a margin above the RBA cash rate to attract deposits, a projected 1% decline in rates over the next 12 months means lower yields for income-seeking investors. In this climate, reinvestment risk—the challenge of reinvesting funds at lower rates—becomes a significant concern, particularly for those depending on fixed-income investments for regular cash flow.
As term deposits mature in this lower-rate environment, many investors will find their income streams diminished, threatening both their purchasing power and long-term financial plans. To counter these effects, investors are increasingly looking for alternatives that offer higher potential returns while maintaining some degree of capital protection.
Below, we’ll explore how adjusting the duration of fixed-income investments can help manage reinvestment risk, and we’ll examine several alternative investment options—including corporate bonds, private debt, and structured credit—that may provide enhanced income for investors willing to accept higher risk. Additionally, we will highlight Arrow Private Wealth’s Lifestyle and Liquidity Portfolios, which offer diversified solutions for income generation, aiming to outperform traditional term deposits and cash investments while balancing risk and return.
Understanding Reinvestment Risk
The chart below illustrates the consensus trajectory of the RBA cash rate through to the end of 2025, showcasing the anticipated rate reductions over the next few years. Historically, banks offer a margin above the RBA cash rate on term deposits, compensating for the inherent default risk within the bank and the competition for investor funds. However, with the chart projecting approximately a 1% decline in rates over the next 12 months, this will likely result in reduced term deposit rates across the board, posing challenges for income-focused investors.
Reinvestment risk becomes particularly significant in this environment. It occurs when an investment, such as a term deposit or bond, reaches maturity, and the proceeds must be reinvested at a time when interest rates are lower. This can have a profound impact on an investor’s ability to sustain their desired income levels. For example, an investor with a term deposit earning 4%, upon maturity, may only be able to reinvest at 2% under the new lower rate environment, effectively halving their income stream.
For those who rely on fixed-income investments as a regular source of cash flow, this reduction in yield not only diminishes current income but can also erode purchasing power over time, further straining long-term financial plans. The prospect of continually reinvesting at lower rates can undermine the consistency of returns, especially in retirement or income-oriented strategies. As a result, many investors are increasingly motivated to explore alternative investment options that offer the potential for higher yields, while still providing some level of capital protection, allowing them to better manage reinvestment risk in a declining rate environment.
How Duration Can Offset Reinvestment Risk
One way to manage reinvestment risk is by adjusting the duration of fixed-income investments. Duration measures the sensitivity of a bond’s price to changes in interest rates and reflects the time an investor needs to recover the bond’s price from its cash flows. Bonds or fixed-income securities with longer durations tend to lock in prevailing interest rates for a more extended period, potentially shielding investors from the effects of a declining rate environment.
Government bonds are often regarded as offering very high credit quality due to the backing of sovereign governments, making them a secure option in terms of default risk. However, despite this high credit quality, government bonds can expose investors to significant interest rate volatility. It is essential to note that longer-duration bonds may be more sensitive to changes in interest rates. For instance, if rates unexpectedly rise, the price of long-duration bonds could fall, exposing investors to interest rate risk. Therefore, balancing duration is critical in portfolio construction, particularly in an uncertain interest rate environment.
Alternatives to Term Deposits for Higher Returns
As cash and term deposit rates are expected to decline, investors willing to accept more risk may find better opportunities in alternative enhanced income investments, including corporate bonds, private debt, and structured credit. These options allow investors to achieve higher returns than traditional cash products but come with different risk profiles.
Corporate Bonds
Corporate bonds are debt securities issued by companies to raise capital. They offer higher yields than government bonds or term deposits because they carry more risk, particularly the risk of default. Investors in corporate bonds are compensated for this risk with a higher interest rate, known as the yield.
Corporate bonds can vary widely in quality. Investment-grade bonds offer relatively lower risk and lower yields, while high-yield or "junk" bonds come with higher risk and higher returns. For investors comfortable with the additional risk, corporate bonds can be a viable alternative to term deposits, especially when yields are more attractive during periods of declining interest rates.
Private Debt
Private debt refers to loans made to companies or projects that are not issued or traded on public markets. These can include loans to mid-sized businesses or infrastructure projects, typically structured as direct loans or credit facilities. Private debt has grown in popularity among institutional and high-net-worth investors due to its ability to offer higher yields than publicly traded debt at the same level of credit quality.
Private debt investments tend to have less liquidity than public bonds and often come with stricter covenants or terms. However, this asset class can provide higher returns due to the added risk of illiquidity, less transparency, and potential default risk. For sophisticated investors, private debt can be an attractive option for income generation, especially when cash rates and term deposit yields are low.
Structured Credit
Structured credit involves pooling together different loans or debt instruments and selling them as securities. These can include collateralised loan obligations (CLOs), mortgage-backed securities (MBS), or asset-backed securities (ABS). The complexity of structured credit products allows investors to access varying levels of risk and return depending on the underlying assets and the tranche they invest in.
Structured credit products can offer higher yields than traditional fixed-income products but require a deep understanding of the underlying risks. Their performance can be sensitive to economic conditions, and the risk of default or loss is not uniform across different tranches of a security. As a result, structured credit is generally suited for experienced investors seeking to enhance returns by taking on more complex risk profiles.
Arrow’s Diversified Solutions to Access Enhanced Income Markets
In light of the expected decline in cash rates over the next 12 months, investors looking for alternatives to term deposits might consider Arrow Private Wealth’s Lifestyle and Liquidity Portfolios. These portfolios offer diversified exposure to income-generating assets while targeting returns above those available from traditional term deposits.
Arrow Lifestyle Portfolio
The Lifestyle Portfolio is designed for investors seeking yield and looking to outperform traditional cash rates over a three-year horizon. The portfolio targets returns of 2% to 2.5% above the RBA Cash Rate over rolling three-year periods. This strategy focuses on consistent distributions, making it attractive to those willing to accept a moderate level of risk. Key features of the Lifestyle Portfolio include:
Running Yield: 7.25%
Yield to Maturity: 7.35%
Allocation: A mix of corporate bonds, subordinated debt, private debt, and structured credit, offering investors a well-diversified exposure to various income-generating assets.
For investors seeking a medium-term solution to reinvestment risk, the Lifestyle Portfolio provides an excellent option to generate higher income compared to cash or term deposits while maintaining a diversified risk profile.
Arrow Liquidity Portfolio
For those with a shorter investment horizon or a greater focus on capital stability, the Liquidity Portfolio offers a balanced and diversified approach to outperform the RBA Cash Rate by 0.75% to 1.5% over rolling one-year periods. The portfolio is designed to provide consistent, low-volatility returns with a focus on liquidity and risk mitigation. Key features of the Liquidity Portfolio include:
Running Yield: 5.15%
Yield to Maturity: 5.43%
Allocation: Primarily invested in cash, term deposits, and high-quality corporate bonds, along with subordinated debt and RMBS/ABS instruments.
This portfolio offers daily liquidity, making it an ideal choice for investors needing quick access to their capital while still targeting yields higher than cash or term deposits. The portfolio’s focus on capital preservation and yield optimisation provides a solution for investors looking to avoid reinvestment risk while enhancing their income in a declining rate environment.
Performance outcomes
The chart and table below showcase the performance of the Liquidity and Lifestyle Portfolios over time, benchmarked against the Bloomberg AusBond Bank Bill Index, which reflects the returns typically achieved from cash investments. Both portfolios have consistently met or exceeded their performance objectives, demonstrating strong results. However, it’s important to recognize that these portfolios carry a slightly higher level of investment risk compared to term deposits. Unlike term deposits, which offer guaranteed returns, these portfolios may experience periods of negative performance due to market fluctuations, particularly in more volatile environments. While the risk remains controlled, investors should be aware of the potential for short-term losses in exchange for the potential of higher long-term returns.
Wrapping up
As the outlook for interest rates suggests a downward trend over the next 12 months, reinvestment risk becomes a pressing concern for investors relying on term deposits or cash investments. With lower rates threatening income streams, exploring alternative strategies that offer higher potential returns while managing risk appropriately is essential.
By adjusting duration and considering investment options such as corporate bonds, private debt, and structured credit, investors can better navigate a low-rate environment. Moreover, Arrow Private Wealth’s Lifestyle and Liquidity Portfolios provide diversified access to enhanced income markets, offering a balanced approach that targets returns above traditional cash products while controlling risk.
Clients and investors are encouraged to contact their Arrow Private Wealth adviser for more personalized guidance and tailored investment solutions. Your adviser can help assess your financial situation, recommend strategies to mitigate reinvestment risk, and enhance your income opportunities in this evolving market.
General Advice Warning:
Any general advice on this page does not take account of your personal objectives, financial situation and needs, and because of that, you should, before acting on the advice, consider the appropriateness of the advice, having regard to your objectives, financial situation and needs. Information contained on this page was correct at the time of posting.