Late last year I opened a 9 month term deposit with an interest rate of 3.50%. Time has flown by, and now as that term deposit is approaching maturity, I’m facing the prospect of having to reinvest it at a drastically lower rate of around 2.80%. These low rates suck!
Interest rates are plummeting everywhere, and with them, the incomes of term deposit holders. Given New Zealanders collectively have $170 billion invested in term deposits, the effect of this will be widely felt. In this article, I’ll briefly look at why rates are falling, alternative investment options, as well as some tips for squeezing extra dollars out of term deposits.
Why are rates dropping?
The Reserve Bank of NZ has been reducing New Zealand’s Official Cash Rate (OCR). The OCR is essentially a lever that can be used to help push the economy in a certain direction:
- Reduce the OCR to help boost the economy
- Raise the OCR to cool down the economy (to prevent severe inflation)
The Reserve Bank has been cutting rates over their concern about slowing economic growth both domestically, and globally. Five years ago, the OCR was at 3.50%, and it has been on a downward slope since then. There was a big rate cut this month (August 2019) from 1.50% to 1.00% and the downward slope isn’t over yet, with short-term forecasts suggesting a further OCR cut may be on the cards later this year. You can see a full history of the rate here.
The OCR influences the economy by influencing interest rates. Rate cuts hope to stimulate the economy by encouraging people to spend and invest more by decreasing cost of lending (like mortgage interest rates, to give homeowners more spending money), and decrease bank deposit and savings rates (making spending and investing more attractive). I won’t get into too much detail about how this works – you can watch the video below to learn more:
Lower rates hurt
My current $10,000 9-month term deposit at 3.50% gives me an after-tax income of $189. At today’s rate of 2.80%, I’d only get $151.20. Looking back 5 years, rates of well over 4% were common. At 4.20%, my $10,000 deposit would have earned me $226.80. Incomes from term deposits are quickly approaching half of what they used to be a few years ago.
Considering $170 billion is in term deposits, and many people like retirees are using them for their income, rate cuts definitely hurt a lot of people, and will make much of the country rethink the use of term deposits in their investment or savings portfolios. So what can you do about the shrinking interest rates?
Fun fact: term deposit rates in early 2008 were over 8%! You can see some data on historical interest rates back to 1964 here
Option 1 – Invest in riskier assets
Bank Deposits are among the least risky places to put your money. The first option to deal with low interest rates is to invest in riskier assets that have potential to deliver higher returns.
1. Bonds and Peer to Peer Lending
Two types of investments that pay regular interest, just like term deposits, are Bonds and Peer to Peer Lending. At the time of writing, Infratil are offering 7 year bonds at a rate of 3.35% – not too much higher than ANZ’s 5 year deposit rate of 3.10%, but you do get the benefit of being able to sell/cash-up your investment at any time.
Rates from Peer to Peer Lending start at 6%, but can easily reach 10%. Of course, both bonds and Peer to Peer Lending expose you to a lot more risk – mainly to default risk, where the borrower/bond issuer may get into financial trouble and is unable to pay back your money.
Dividends from high dividend yielding shares can be used to replace interest income from term deposits. These are examples (not recommendations) of New Zealand companies that pay a regular, high dividend, and at the time I wrote this (20 August) their gross dividend yields are:
- Genesis Energy – 6.87%
- Heartland Bank – 7.62%
- Air New Zealand – 11.11%
- Spark NZ – 7.99%
- Argosy Property – 5.37%
However, shares carry even more risk than bonds and peer to peer lending. Companies can lower or cancel their dividend payments, and/or their share prices can fall. The following two are examples of companies that paid decent dividends three years ago, but are now in a sorry state:
- Sky TV – share price was $4.86, now $1.22. Dividend currently suspended.
- Fletcher Building – share price was $10, now $4.87. Dividend was completely suspended during 2018.
There’s many other investment options, and a few examples are:
- Funds that invest in high dividend paying companies, for example, the Smartshares New Zealand Dividend ETF. This fund currently has a gross yield of 4.90% and is available on InvestNow or Sharesies.
- Funds that don’t have a dividend focus, but still have a decent dividend yield, for example, the Smartshares NZ Top 50 ETF. This currently has a gross yield of 3.72%.
- Property – mortgage rates have also gone down thanks to the OCR cut. If you already have a mortgage, you could use your term deposit money to pay it off, offset it, or stick in a revolving credit account (but this may come with its own unique risks).
Investing in riskier assets is definitely not for everyone. Not everyone can afford to or wants to take on more risk. Those investing for the short-term (like those about to buy a house), are best to stick with bank deposits, unless they don’t mind having their house deposit exposed to potential drops of the share or bond markets.
Then there are those who are risk adverse. My parents are good examples of this – they got hurt by the 1987 market crash and won’t go anywhere near shares these days. They have left a lot of money on the table by not investing in shares, but at least they sleep better at night, knowing their money isn’t at (high) risk.
Also as interest rates fall, buying assets like bonds and shares for their higher yields becomes less effective. Since demand for these assets increase when interest rates fall, their prices increase, reducing their yields. For example, 3.5 years ago the yield on BNZ090 bonds were 5.25%, and has since gone down to 2.50%. Same with Goodman Property Trust – 2.5 years ago it had a dividend yield of 5.6%, now it’s down to 3.7%. Finding quality, high-income producing assets becomes harder and harder as interest rates fall.
Option 2 – Stick with term deposits
Some people have no choice but to take this option – as mentioned above, many are not in a position to take on more risk. Unfortunately they’ll have to suck it up and accept the lower rates. However, there are a few things you can make sure you’re doing to get the most out of term deposits. Let’s start with an initial term deposit and see how each tip affects the amount of interest we could earn:
Initial term deposit – Our initial term deposit will be $10,000 invested for 1 year at 2.75% with ASB. We have a tax rate of 33%. This gives us an after-tax interest income of $184.25 at the end of the 1 year term.
1. Make it a PIE
Most banks offer a PIE version of their term deposits (often known as a Term PIE). Term PIEs work the same as term deposits, but have different tax treatment where your interest income is taxed at your Prescribed Investor Rate (PIR). PIRs are capped at 28%, meaning those on 30% or 33% tax rates will benefit from investing in a PIE.
Term deposit 1 – With a Term PIE, our deposit will be taxed at 28% instead of 33%. This increases our after-tax interest income to $198, which is $13.75 more than the initial term deposit, and is equivalent to having an interest rate of 2.96%.
2. Compound your interest
By default, banks pay you any interest you earn from a term deposit at maturity (at the end of the term). But these days it’s common for banks to offer options to have your interest paid out more frequently (e.g. every 3 months). Further to this, they often offer the option for you to compound (re-invest) the interest into the same term deposit, so that you can earn interest on your interest.
Term deposit 2 – By compounding our interest quarterly, our interest income increases to $199.42, which is $1.42 higher than Term Deposit 1. We have now increased our interest income by $15.17 over our initial term deposit.
An extra $1.42! I know this tip is hardly worth it – the compounding effect is stronger with higher interest rates. But at least it’s better than letting the bank keep that money.
3. Shop around for better rates
Special rates aren’t as common as they used to be, but still worth looking out for. For example, ASB are offering a 7 month term at 3.00% – their highest term deposit rate on offer. However, this comes at a risk as you are forced to reinvest your money earlier (at 7 months vs 1 year), at potentially a much lower rate.
It’s also worth looking for better rates at other banks. For your convenience, here’s the links to the term deposit rate pages of our major banks, as well as to interest.co.nz, which has a rate comparison page:
Term deposit 3 – The highest 1 year rate out of the major banks is ANZ at 2.85% (compared to ASB’s 2.75%). This would give us an after-tax return of $206.79, which is $7.37 more than Term Deposit 2 with ASB. We’ve now increased our interest income by $22.54 over our initial term deposit.
If you can’t be bothered signing up to a new bank to get the better rate, then asking your existing bank to match the rate is worth a shot.
4. Invest in a riskier bank
Smaller banks like Heartland Bank often offer higher interest rates than the main banks. However, these banks have lower credit ratings, so come with higher risk. From Liz Koh’s opinion piece on Stuff.co.nz:
Our main banks – ANZ, ASB, BNZ and Westpac have an AA- rating. That’s a probability of default of around one in 300 over five years. By comparison, Co-operative Bank, Heartland Bank and SBS Bank have a rating of BBB which reflects a one in 30 chance of default in five years.
In addition, if you’ve had a look at Interest.co.nz‘s rate comparison page you may have also seen credit unions and finance companies on the list. Risk increases exponentially as you get to lower credit ratings, and a finance company with a BB rating has a 1 in 10 chance of default! Given the track record of finance companies in NZ (67 collapses between 2006 and 2012), I’d personally avoid these finance companies.
Term deposit 4 – With Heartland Bank we can get an interest rate of 3.05% for a 1 year term deposit. This would give us an after tax return of $221.41, which is $14.62 more than Term Deposit 3 with ANZ. With all the tips combined, we have increased our interest income by $37.16 over our initial term deposit.
5. Stagger maturity dates
This tip is a little different so I won’t compare it to the above examples. Its purpose is to address the one of the big downsides of term deposits, which is having your money locked up for a period of time. You can always invest in deposits for shorter terms, or in a saving account, but these come with lower rates – for example, the 3 month rate at Heartland is 2.6%, while their 1 year rate is 3.05% (however, this is less of an issue these days, as the gap between shorter term and longer term rates has fallen dramatically).
A potential solution for this is to stagger your maturity dates. For example, Instead of investing $100,000 in one term deposit, you could create four $25,000 term deposits:
- A deposit maturing in 3 months time (at 2.60%), then reinvested for one year (at 3.05%)
- A deposit maturing in 6 months (at 3.00%), then reinvested for one year
- A deposit maturing in 9 months (at 3.00%), then reinvested for one year
- A deposit maturing in 1 year (at 3.05%).
This allows you to invest in longer term (and hopefully higher rate) deposits, while having the ability to access $25,000 of your money every 3 months. Longer terms also allow you to lock in your rate for longer, which is ideal in an environment where rates are predicted to fall even further!
By staggering the maturity dates like we have above, after one year we’d earn interest income of $2,173.88. In comparison, investing the whole $100,000 into rolling 3 month term deposits, would only earn $1,753.41 in interest.
Unfortunately, these tips won’t dramatically increase your returns. Everyone is in the same low interest rate boat, and there just isn’t any easy way to hack yourself out of this boat.
At least New Zealand’s term deposit rates are higher than in many other countries. The below is a comparison of rates for a $10,000 1 year term deposit between the big 4 New Zealand and Australian banks (as at 22 August):
|NZ Average||2.79%||1.63%||AU Average|
Falling term deposit rates present a challenge for many savers and investors. Term deposit holders are forced to take on more risk to maintain former levels of income, and those that can’t afford the extra risk are stuck in a difficult position. There are tips you can follow to squeeze more dollars out of term deposits, but they won’t fix the fundamental issue of low rates.
However, I also see this situation as an opportunity to learn, gain more investing skills and knowledge, and get out of our comfort zones – declining term deposit rates was what motivated me to invest in assets like shares, bonds, and peer to peer lending in the first place. As for my 9 month 3.50% term deposit, I’m not planning to reinvest it for another term. I’m fortunate to be in a position where I can take on more risk and have been doing so, as you may have seen in my What I’ve been investing in series.
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The content of this article is based on my personal opinion and should not be considered financial advice. The information should never be used without first assessing your own personal and financial situation, and conducting your own research. You may wish to consult with a qualified financial advisor before making any investment decisions.