Why term deposit rates are about to stall

Term deposits are becoming attractive again, with some Australian banking institutions offering a one-year term deposit rate over 5%. This is in stark contrast to the beginning of 2022, when available rates on term deposits were less than just 1%.

A term deposit is a cash investment held at a bank or other financial institution for a fixed amount of time, or term, at an agreed rate of interest.

The investment is typically viewed by investors as a relatively risk-free, safe investment structure. The term can range from just one month to up to five years, and have a low minimum deposit - which makes them accessible to the majority of investors.

It has been more than 10 years since the one-year term deposit rate was over 4%, which is an important milestone for a number of reasons.

Four per cent is the cash rate average for the past 30 years. In some ways, it represents the risk-free rate of return.

Importantly, when comparing income return from the Australian share market, the S&P/ ASX 300 Index has an average yield of 4.2%, before imputation credits, for the past 20 years, so the current term deposit rates compare favourably with the dividend yield from Australian shares.

It should also be noted that while there are higher income returns, such as those within high yield credit, infrastructure and property trusts, they all have a level of risk that is far higher than the term deposit with a government guarantee (up to $250,000 per authorised deposit-taking institution).

A term deposit investment provides the 'security' factor required for a portion of investments, and particularly for investing money that will be spent in the next few years.

For retirees, in particular - who are after assets that produce a consistent income level - term deposits have been disappointing for the past 10 years.

And surprisingly, Australian shares have had a more consistent income level than term deposits since the GFC in 2008 and 2009.

However, now that interest rates have moved back up, retirees and those nearing retirement will again explore term deposits to produce the higher income return needed.

Given we are nearing the end of the interest rate rising cycle - or arguably even there - term deposit rates will not rise much further than current rates, and most banks will offer up to five-year term deposit rates.

For investors not wanting any risk with an investment and prepared not to access the capital for up to five years, a rate above 4% is an attractive interest return. However, if there is a chance the capital may be required within the investment period, often the break fee penalty means ­­­­­­­­­­­­a short-term deposit period will provide a better interest return.

Therefore, this will start to have long-term impact on asset allocation.

The combination of cash and fixed interest forms part of a well-diversified investment portfolio, with about 40% required for a balanced portfolio with a long-term allocation.

However, the historically low returns for the ten years up to 2022 forced many investors to take on more risk in their portfolio, particularly for retirees who were drawing out a percentage of their pension, given the need for income which a term deposit didn't offer.

And while interest rate rates may fall over the coming years, a move back towards a higher allocation of fixed interest will inevitably start to occur, if not already.

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