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Interest rates on savings accounts were over 5% p.a. in 2011… only 10 years ago. Today, you would be lucky to receive more than 0.5% p.a.! That means your savings won’t even keep pace with inflation, let alone provide you with any investment return.
As such, many investors are wondering what to do with their cash savings, other than depositing the money with a bank.
This blog discusses some alternatives to bank deposits. However, please do not make any financial decisions solely on the information contained here. It is general information only and does not consider your unique circumstances. It important that you receive personalised and independent financial advice before investing any monies.
I have listed each investment option in order of risk (the lowest risk options first).
Option 1: Deposit monies in an offset linked to a mortgage
If you have a variable rate mortgage, typically the best use of cash savings is to deposit the monies in a linked offset account. Given home loan interest rates range between 2% and 3.5% (depending on whether it’s a home or investment loan), this will save (or make) you a lot more interest compared to depositing your money in a savings account. Most importantly, it’s a risk-free return. That is, your return will always be equal to the mortgage’s interest rate – there is no risk.
Of course, you should offset non-tax-deductible (home loan) debt first. Once your home loan is fully offset/repaid, you should then offset investment debt.
Sometimes people worry that offsetting an investment loan will reduce their negative gearing tax benefits. However, firstly, negative gearing benefits are relatively small at current interest rates – investors aren’t saving huge amounts of tax anyway. Secondly, if you invest your cash savings elsewhere, you will have to pay tax on any returns (unless one spouse has a low/no income). Therefore, as both options have tax consequences, they net each-other out, and are therefore not relevant.
Option 2: Invest in government and treasury bonds
A bond is a loan instrument where the investor is the lender, and the borrower is the issuer. The federal and state governments issue bonds to raise debt. You can invest in these bonds i.e. in essence you lend money to the government.
Most states have high credit ratings (AA or AAA), which means these bonds are extremely low risk. The federal government has maintained its AAA rating (the highest rating) despite significantly increasing its borrowings over the past year.
Australian government bond index funds are yielding (interest rate) in the range of 2.5% and 3% p.a., which is obviously a lot better than deposit rates.
International bonds typically provide lower income returns and you need to be mindful of foreign exchange rate fluctuations.
Option 3: Invest in Australian corporate bonds
Corporate bonds are similar to government bonds. However, they are issued by companies, often large, listed companies. Corporate bond index funds only invest in investment-grade rated bonds, which means they are relatively low risk, albeit higher risk than government bonds.
Corporate bond index funds are currently yielding between 3% and 3.5% p.a. – sometimes more, depending on the type of fund and how it invests.
Option 4: Invest in hybrid securities
Hybrid securities are issued by the Australian banks. They are instruments that have both bond and share characteristics e.g. they will convert to normal shares if certain events occur. They pay a variable rate coupon (interest rate) that is typically fully franked i.e. franking credits are attached to the coupon payment which makes it tax-effective.
Actively managed hybrid funds are currently yielding circa 3.5% (gross).
Option 5: Invest in REIT and Infrastructure
Infrastructure involves investing in businesses that operate high-cost assets such as toll roads, communication assets, airports, electrical systems and so on. These investments usually generate predictable and stable incomes, particularly in a low interest rate environment. However, the value of these assets have been negatively impacted by Covid lockdowns because people aren’t traveling as much. As such, they are trading on lower multiples and therefore make more attractive investments. Infrastructure funds typically yield between 3% and 4% p.a. and at the moment, and there is probably some capital appreciation upside (post Covid).
Australian Real Estate Investment Trusts (REIT) tend to have too much exposure to retail property e.g. shopping centres. Therefore, my preference is to invest in international (currency hedged) REIT’s, as they tend to offer more diversification. Again, the value of some of these assets have been negatively impacted by Covid e.g. holiday parks/resorts. However, these valuations should recover over the coming years as the impact of Covid dissipates. Global REIT’s current yield in the range of 2% and 4% p.a. with some capital upside.
Option 6: invest in shares
You can invest in Australian listed shares to generate dividend income. Of course, dividend income is not guaranteed and could change at any time. In addition, the value of your investment (value of shares) could change too. Therefore, investing in shares purely for income is much higher risk than all of the above options.
That said, if you are able to tolerate the volatility and you won’t need to sell any investments over the next 5-10 years, then in the long run, it could form part of a good strategy.
There are a number of low-cost index funds that focus on maximising dividend income. Gross (pre-tax) income returns currently range between 5.5% and 9.5% p.a. Again, these income returns can be volatile, as can be the value of these investments. You cannot expect to generate higher returns without accepting higher risk.
Depositing monies in offset is a lazy strategy
Many investors are concerned that accumulating cash in an offset account doesn’t really generate a high return, because mortgage interest rates are so low.
There are two competing considerations to take into account.
Firstly, the best time to repay debt is when interest rates are low as more of your repayment can go towards the repayment of loan principal, not interest. The next 3 to 5 years at least, provides an excellent opportunity to repay debt.
Conversely, in the long run, investing in alternative assets will likely generate higher returns (i.e. more than the mortgage interest rate). Particularly if you focus on overall returns (capital + income), not just income.
If you have substantial savings, use multiple options
Like with most things is life, moderation is the best approach. Investing in a combination of low and higher risk options allows you to construct a portfolio that is commensurate with your risk profile and financial goals.
The correct allocation of your cash savings will depend on your financial position, investment strategy, goals and risk appetite.