The role of cash and bonds in your portfolio and what’s available

Inflation is the natural enemy of bonds because bond prices fall as interest rates rise, but the prospect of lower inflation and interest rate cuts in 2024 is altering the investment equation.

Again, there are various ways you can access bonds and other fixed interest investments. And while they may all be lumped in to the “defensive” part of your portfolio, there’s a wide variety of risk and return.

Cash

Bank high interest savings accounts are offering the best interest rates in years – above 5% in many cases at the time of writing, although the terms and conditions can be restrictive.  

Some things to watch out for are a high introductory rate that reverts to a lower base rate after a few months, minimum monthly transactions, and a requirement to grow your balance each month.

Increasingly, investors are looking beyond bank accounts to diversified cash exchange-traded funds (ETFs). These ETFs invest in cash products and deposits offered by reputable banks, often at better rates than you could get at your local bank.

Instead of the rigmarole of opening a bank account, with often limiting conditions, or locking your money away in a term deposit, you can buy and sell an ETF on the Australian Securities Exchange (ASX).

Distributions (interest payments) are usually paid monthly.

On the downside, unlike bank accounts, cash ETFs don’t enjoy the government guarantee for deposits up to $250,000.

The table below shows the biggest and most popular cash ETFs, fees and returns, but is not a recommendation for any product.

ASX Code	Base fee	1-yr total return
AAA (BetaShares)	0.18%	3.88%
BILL (iShares)	0.07%	3.85%
ISEC (iShares)	0.12%	4.00%

Source: Issuer websites as at 5 December 2023

ISEC is higher risk with potentially higher returns than the others as it can invest in higher yielding securities like floating rate notes and commercial paper.

Term deposits

Term deposits have long been a popular way to lock in guaranteed income at a fixed interest rate for a set period of time. For SMSF investors in retirement phase, they also allow you to manage your future cash flow by staggering the maturity dates of multiple term deposits.

According to the ASX Australian Investor Study 2023, term deposits are the third most popular investment with SMSFs (32% of SMSFs hold them), after Australian shares (73%) and residential investment property (41%).

Term deposits are available for terms of one month to five years. Generally, the longer the term the higher the interest rate and the best rates tend to be offered by smaller banks and financial institutions.

At the time of writing, the best rate for one-year term deposits is 5.35%, just below the inflation rate of 5.4% although inflation is expected to fall. The big four banks are all offering around 5% for one-year term deposits.

As well as the interest rate and term of the deposit, other things to look out for when choosing a term deposit are:

• Payment options – some lenders offer interest payments monthly, biannually or annually, but you may get a better return if you opt for payment when the term ends
• Penalties apply for early withdrawal, and vary depending on the lender
• A linked bank account is required by some banks, while others allow a stand-alone term deposit using your own bank account.

Pros

No set-up or account-keeping fees, no monthly account conditions or deposit requirements, and a government guarantee for deposits up to $250,000.

Cons

You won’t benefit from rising interest rates during the term of your deposit, but you will benefit from locking in a higher rate if rates fall, so try and match your term to expectations about future interest rates. Rates can be lower than high interest savings accounts and penalties for early withdrawal limit flexibility.

Bonds

A well-diversified bond portfolio tends to offer reliable income payments with less volatility than shares and a better coupon (interest) rate than cash investments as a reward for holding your bonds to maturity.

However, the defensive role of bonds has been tested in recent years as a rapid rise in inflation and interest rates resulted in extreme market volatility.

The interest rate (yield) on 10-year government bonds spiked as central banks jacked up official interest rates to stem inflation. That’s good news for investors who intend to hold their bonds until maturity.

Ten-year government bonds issued by stable, credit-worthy governments are viewed as ‘risk free’ because the government guarantees to pay you back when the term expires. The yields on 10-year government bonds were 4.24% in the US and 4.39% in Australia in early December 2023.

However, if you sell your bond before maturity you’ll get the market value, which could be higher or lower than face value. Because bond prices fall as yields rise (and vice versa), rising interest rates have pricked the bond market bubble that inflated in the era of easy money between the GFC and COVID-19.

Despite the uncharacteristic volatility, there’s always a place for bonds in a diversified portfolio. What’s more, when central banks begin cutting interest rates as many market observers expect in 2024, investors who have locked in a high rate for the long term will be sitting pretty.

Broadly, there are two categories of bonds:

• Government bonds issued by Australia and other nations under various names, for example, US Treasuries, UK Gilts and German Bunds. In Australia, semi-government bonds are also offered by state and territory governments.
• Corporate bonds issued by large companies offer higher yields with higher risk than government bonds because payments are not guaranteed in the event of a corporate failure, so the creditworthiness of the issuer is extremely important. Other types of corporate bonds such as mortgage-backed securities and private debt offer still higher yields with higher risk.

As it’s difficult for individuals to achieve a diversified bond portfolio with direct investments in bond issues, which often require a high minimum investment, most individual and SMSF investors access bonds via managed funds or exchange-traded funds (ETFs).

You can buy managed funds or ETFs in specific types of bonds such as government bonds, high yield bonds, mortgage or private debt, or a diversified bond portfolio. Actively managed funds generally have higher fees than ETFs that track an index.

Pros

Bonds traditionally offer reliable income with less risk than shares. If interest rates and bond yields fall as expected, and bond prices rise, investors could get capital appreciation as well as income from their bonds. Happy days!

Cons

Inflation is the enemy of bonds, as rising inflation feeds into higher interest rates and falling bond prices. Even at their recent highs, yields on 10-year bonds were below inflation. When buying corporate bonds, it’s imperative to understand the risk profile of the underlying companies.

Hybrids

Hybrid securities, as the name suggests, combine features of shares and bonds. They offer regular income like bonds, but their value can fluctuate like shares.

Hybrids have been extremely popular with Australian investors because of their relatively high yields and the household names issuing them, notably the big four banks. At the time of writing, bank hybrids listed on the Australian Securities Exchange (ASX) had running yields of 7–9%.

However, the Australian Securities and Investments Commission (ASIC) Moneysmart website warns they are complex products with risks that investors need to understand before parting with their money.

Hybrids generally pay a fixed or floating rate of return until a specified date, but as Moneysmart points out, there’s no guarantee on the amount and timing of interest payments. As each hybrid issue is unique, it’s important to read the prospectus for details and consider getting independent financial advice.

• Banks can convert their hybrid issues – also called Tier 1 capital – to shares if they get into financial difficulties. The shares may be worth less than your initial investment or written off completely, protecting the bank’s depositors at the expense of hybrid investors.
• Listed and unlisted companies can also issue corporate hybrids, generally referred to as ‘subordinated notes’ because hybrid investors get paid last if the company becomes insolvent. Companies can also defer interest payments and the return of your capital.

In September 2023 the Australian Prudential Regulation Authority (APRA) announced a review of hybrids following a handful of overseas bank failures earlier in the year raised alarm bells because of the relatively large number of retail investors in Australian hybrids. APRA is due to release its findings early to mid-2024.

Investors can purchase individual hybrid issues or gain exposure to a portfolio of hybrids via a managed fund or ETF. Some diversified bond funds also include hybrids.

Pros

Hybrids offer attractive income and are issued by major banks and other companies.

Cons

Unlike bank deposits or Australian government bonds, hybrids are not government guaranteed. Interest payments can be deferred, hybrid investors are often last to get their money back if the issuer becomes insolvent, and the security can be converted to shares if the issuer gets into financial trouble.

The bottom line

Cash, term deposits, bonds and hybrids provide reliable income and diversification for your investment portfolio. Bonds and hybrids are not well understood, so it’s important to do your due diligence and research the creditworthiness of the issuer, or the underlying investments in a managed fund or ETF. Because of the complexity of many products, it may also be worth considering independent financial advice.