by
Philip Brown, Head of Research | Feb 05, 2024
To understand the difference between deposits and bonds, we analyse both types of investment, highlighting the features and benefits of each.
Both term deposits and bonds belong to the fixed-income asset class. There are some strong similarities between the two financial instruments at a high level. Both involve committing money now against the promise of that money back, with interest, in the future.
The key difference between a term deposit and a bond is the number of investors involved. A term deposit is an agreement between the investor and the bank – there’s no one else involved, and you might be the only investor who has that exact investment agreement with the bank. In contrast, a bond is a standardised investment that many different investors share at the same time.
While that might sound esoteric, it actually drives a lot of subtle differences in the in the details of the investment. These details are important for investors to understand in order to get the best out of both investment types.
Term Deposits
A Term Deposit is, at its simplest, a deposit of cash in a bank at a fixed interest rate to a specified future date. They can be as short as a few days or as long as multiple years, though one month to six months is the most common time frame.
Term Deposits remain very good relative value investments, by which we mean the interest paid on them is good given the very low risk involved. For complicated reasons related to bank regulation, banks have a strong preference for the longer types of Term Deposits, meaning higher yields can often be obtained.
Coupled with the government guarantee on deposits less than $250,000, Term Deposits are essentially “risk-free”. If you’re fortunate enough to have more than $250,000, you can split those funds between institutions and still access the guarantee as it’s available per entity, per institution.
Many investors went to 100% cash during the GFC as it provided known income and a return of capital at maturity.
Bonds offer exactly the same proposition. A known income and repayment of capital back at maturity. Yet bonds offer important protections over cash for minimal additional risk, but given that additional risk, they also offer higher returns.
What are some of the benefits of Bonds vs Term Deposits?
1. Bonds offer fixed, variable, and inflation linked interest payments
Most term deposits are a fixed-rate investment. If interest rates start to rise, investors have to wait until maturity to take advantage of higher rates on offer, although they can break the agreement, but that usually involves a fee or loss of interest earned.
In contrast, because bonds group together many investors at once, they can offer more features than a straight fixed-rate term deposit. There are three main types of bonds:
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Fixed rate bonds.
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Floating rate notes.
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Inflation linked bonds.
Fixed Rate Bonds
A fixed rate bond is a security that pays a fixed pre-determined distribution or coupon. The coupon of a fixed rate bond will be set at the time of issue and not change during the life of the bond. Fixed rate bonds also will return the initial investment (known as face value) at the final maturity date.
The Commonwealth Government, state governments, banks and corporates all issue fixed rate bonds in Australia.
Fixed Rate Bonds are quite similar to term deposits, but are usually longer. Government bonds can be as long as 30 years to maturity, though most are around 10 to 12 years when issued. Corporate bonds are mid-ranking, with most issuance being around 5 or 7 years when issued.
Floating Rate Notes
Floating rate notes (also sometimes called variable rate bonds) have an interest payment that does change over the life of the bond. The way coupons change over time depends on which currency is being used. In Australia, floating rate notes are benchmarked to the Bank Bill Swap Rate (BBSW). BBSW is calculated each business day, but most floating notes will reset to the prevailing BBSW once per quarter.
Floating rate notes usually pay interest quarterly based on a three-month BBSW plus a margin. The margin is set at the beginning of the investment and doesn’t change, even though the BBSW rate will change.
Floating Rate Bonds Example:
Let’s run through an example: say the interest rate, set at first issue of the bond was BBSW + 3%. If BBSW was 3.25% at first issue, then the interest rate payable to the investor for that first period (at the end of the quarter) would be 6.25%. (3% is the minimum set rate throughout the life of bond, and 3.25% is the current BBSW rate example). Because the bond is paying quarterly, the coupon payment is 6.25% x principal x ¼.
Once the first coupon period ends, a new BBSW rate set is taken at the rate that prevails on the coupon day. If BBSW increased during that first quarter because the RBA was now expected to raise interest rates, the second BBSW rate set might be 3.75%; if so, the second interest payment date would have a rate of 3.75% + 3% = 6.75%.
In this way floating rate notes keep pace with both the changes in the cash rate and market expectations of imminent changes too. Investors don’t have to worry about losing out on interest rate rises, nor reinvesting for short periods.
Inflation linked Bonds
Inflation linked bonds are most like fixed rate bonds, but with an added feature to protect the investor from inflation.
In a regular fixed rate bond, the initial investment is likely to be the face value of the bond (if you buy the bond when it is first issued). The bond will pay coupons over the life of the investment and then return the original face value at the final maturity date too. However, thanks to inflation, the purchasing power of that investment will likely have changed. So even though you receive back the initial investment, you may lose in a real value sense if inflation is higher than anticipated.
Inflation linked bonds are designed to solve that problem. Instead of paying coupons and a final payment based on the original face value, the value of the principal of the bond is increased each quarter at a rate linked to the published inflation rate (hence the name, inflation linked bond). In this way, the return on the bond is linked directly to inflation.
Inflation linked bonds are normally quoted as having a real yield, which is the yield over and above inflation. For example, a 3.25% real yield suggests the bond will return CPI + 3.25%.
Because inflation linked bonds have both an inflation linked component and a yield over and above inflation, they are exposed to both inflation risk and interest rate risk.
2. Interest is paid either quarterly or half yearly for most bonds
Interest on most term deposits is paid at maturity, although if the term exceeds 12 months, it is usually paid annually. Banks will pay more frequent interest, but the interest earned is usually reduced to compensate.
Fixed rate bonds pay half-yearly interest, and floating rate notes and inflation linked bonds usually pay quarterly interest, which is great for those investors in retirement wanting regular cashflow.
3. Liquidity – the ability to access your funds
Term deposits are not liquid investments; investors agree to forgo access to those funds for a pre-determined period. If investors want to access their funds, they are usually faced with break fees or penalty interest.
Bonds are generally liquid investments; that is, they can be easily bought and sold in the secondary market, where they are actively traded. (This is a feature of the fact that bonds are investments where many people have the same investment exposure.) There is no requirement to hold bonds until maturity. There are no fees as such to transact; brokers take a small margin between buyers and sellers, similar to the way foreign currency markets work.
4. Bonds offer the opportunity for capital gain
Because there is an active secondary market for bonds, their prices can fluctuate. Meaning there is an opportunity for capital gain. Fixed rate bonds will show the greatest variances due to the fact their interest payment is fixed – the prevailing market interest rate might be very different to the interest rate fixed on the bond months, or years ago. If interest rates fall, these bonds will be highly sought after, and the bond prices will rise.
A term deposit will protect income as will a fixed rate bond, but it is only the fixed rate bond that has the capacity to increase in capital value. This provides an important protection. Usually, when shares and other common investments are falling in value interest rates will also be falling, meaning bond prices will be rising. In this way the gains on fixed rate bonds help offset losses elsewhere in your portfolio.
Bonds can trade at a discount (below the price they were first issued) or at a premium (above the price they were first issued). Buying bonds at a discount means that if you hold them to maturity, you can expect a capital gain.
A note of warning – selling bonds prior to maturity can result in a loss if the bonds are trading at a discount. But holding bonds to maturity will mean you receive the initial face value (usually $100) back unless the company goes into default. The risk of this happening is typically measured by the yield on offer by the bond - the lowest-risk government bonds have the lowest return, while higher risk corporate bonds have higher yields.
5. Better returns for a marginal increase in risk
Each month, we update our Wholesale and Retail sample portfolios to provide investors with an indication of what a balanced bond portfolio can potentially yield.
Our current Wholesale Sample Portfolios are available by clicking here
Our current Retail Sample Portfolios are available by clicking here
Summary
- Bonds have protective qualities that aren’t available in other asset classes.
- Diversification as always remains key to protecting your wealth and bonds should feature in every investment portfolio.
In summary, when considering term deposits and bonds, it's important to weigh up the different characteristics of each investment type and how they align with your financial goals and risk tolerance. While term deposits offer simplicity, a government guarantee of up to 250K and fixed rate interest, bonds can contribute to a well-diversified portfolio through additional benefits such as liquidity through the active secondary market, higher returns, various interest options, and differing risk profiles depending on the issuer. Diversification remains key to protecting wealth, and incorporating bonds into an investment strategy can provide stability and income, making them a valuable component in a comprehensive and resilient portfolio.
*Current face value on inflation linked bonds represents the inflation adjusted face value.
**Yield for floating rate notes is the swap rate to maturity/call plus the trading margin.
**Yield for ILB equals real yield plus a current inflation assumption of 2.5%.
***ILB running yield quoted is a commencing value, given current indexation, but will accrete with inflation.
Black = retail and wholesale investors, red = wholesale investors only
Prices accurate as at 21 November 2023 for retail sample portfolios and 6 December 2023 for wholesale sample portfolios