Term deposits are no longer the investment they used to be, with investors experiencing diminishing real returns and in some instances a real loss. Not only are they making a loss, but investors are being taxed for the privilege of the losses they are incurring.
If you don’t believe us, we’ve provided the calculations below investors like you need to make to realise their real net return (post inflation and post-tax).
At the very least this article will make you change the way you look at term deposits and at the very best it will put you on the path to find better term deposit alternatives.
What is the purpose of a term deposit?
The purpose of a term deposit is to provide you with a fixed interest return and a high degree of security, that on maturity guarantees the return of your capital.
This asset class traditionally was a way to reward savers, especially retirees and a way to create market liquidity. However, as interest rates dropped, the money supply increased and the purchasing power of each dollar errored, term deposits have struggled to provide a real net return.
What is my real net return on a term deposit after tax and inflation?
What most bankers fail to tell you when quoting you your term deposit rate. Is that your actual net real return is a lot lower, if not negative.
What your real rate of return is on a term deposit (adjusted for inflation only)
Firstly, you must calculate what your real rate of return is. Which is the nominal rate of return of the term deposit, less the inflation rate at the time. This is what is known as your real return.
The problem however is that the inflation figure quoted by government is generally understated. One of the things we consider at Royce Stone Capital is increases in money supply over a period of time, when determining what the real inflation rates is.
This is a subject that you must do your own due diligence on.
Tax structures effect your term deposit returns
Secondly, we must calculate the portion of your term deposit return that will be taxed. This is subject to your tax structures, allowed expenses and the tax rate of the day on the applicable structure.
The problem is that in most instances the tax rate is applied to the nominal term deposit rate of return, and not the adjusted real rate of return (adjusted for inflation).
Do you realise the problem here? If your term deposit rate is 5%, and the real inflation rate is 5%. You are not actually making a gain, but yet you are being taxed as though you are.
What your real net return is on a term deposit (adjusted for inflation and tax)?
When you deduct inflation and tax from your nominal term deposit return, this leaves you in reality with very little or worse yet a negative net return.
For example, if your term deposit rate is 5%, and inflation is 3%. Your real return is 2%.
If your tax rate is 25% calculated on the 5% term deposit rate, your effective tax is 1.25% assuming you had no other deductions.
So, your real net return after tax is .75% (5% - (3% + 1.25%)).
Now imagine the inflation rate was 5%.
Then technically you’d be at negative 1.25% return. (5% – (5% + 1.25%)).
So, in essence you were taxed for the privilege of making a negative net real return.
This is simply the reality no one is talking about, that we are willing to. This is why it’s important to do your own homework as to what the real inflation rate is.
What does the bank do with my term deposit funds?
Subject to the country and banking system you’re in, the bank can use your funds as part ofa fractional reserve banking system. Allowing them to lend your money out to other borrowers in the market.
The bank then makes a margin, between the sale price that it lends your money out on, versus the term deposit rate it pays you.
Your catch 22
Now that you’ve become aware of what your real net return is, you have the option to keep investing in term deposits, or to find a better way.
The problem is for most investors, is they won’t act out of fear, but a decade later they will wonder why they don’t have enough money to survive.
Term deposit alternatives
Our family office clients and HNW investors quicky realised that term deposits were in fact losing them money in real net terms. Additionally, they realised, that their money was in fact making the bank money and not them.
So, what are your options?
Well, it depends on how much money you have and your tolerance for risk.
Mortgage-backed private credit as a term deposit alternative
When a bank takes your term deposit and lends it out, it typically takes property as security. Family offices and HNWs realised they could do the same thing through mortgage-backed private credit. In other words, they decided to become the bank themselves.
Investing in mortgaged backed private credit can happen in one of two ways. You either become a direct lender yourself (if you have financial capacity), or you invest into a private credit fund.
You can read more about active investments and passive investments in private credit here.
Becoming the bank with mortgage-backed private credit
Typically, private credit borrowers do not meet bank credit criteria, however their security is often the same as what a bank would take.
Mortgage-backed private credit typically involves lending between 30% to 80% of a property’s value, taking a first mortgage as security, interest only terms and loan terms of 6 to 12 months (in some instances 3 years).
The added benefit is that family offices can charge a risk premium (due to them absorbing the credit risk and providing funds quicker than a bank). Allowing them to generate higher returns than what a term deposit would give them.
Rates are usually between 8% to 12% p.a. Meaning you’re getting almost double if not triple what a term deposit would provide.
By being a direct lender themselves and using firms like us to originate deals for them, family offices have deal control and direct security.
To learn how we generate an alpha return in private credit click here.
Our family office clients have also learned to make money using the banks money through private credit market arbitrage. You can read our article here about this.
Investing in a private credit fund
Reputable private credit funds can provide stable returns of 7% to 10% p.a. with a high degree of security. Subject to their lending criteria and underlying security. These make for a great alternative for smaller investors, and we suggest investors avoid investing in construction lending funds, unless they are highly reputable.
Emerging market bonds and or term deposits
Emerging markets offer government bonds and term deposits that provide higher returns than those in western nations. They do however carry higher sovereign risk, currency risk and possibly capital control risks. Key benefits of investing in emerging markets besides the higher returns, is diversification and moving funds offshore, in case there are sovereign issues at your place of residence.
Corporate bonds
Corporate bonds offer higher returns than term deposits and generally are quite liquid. We generally find US corporate bonds to be quite attractive and liquid. However, this comes with company risk, market price risk and currency conversion risk as well.
Private credit - Australian private corporate bonds
In the mid-tier market, there are private credit corporate bonds that get issued with corporates guarantees, providing returns of 9% to 13% p.a. Generally, these companies must be making at least $20M in profit per annum and are looking for bank alternatives. These are generally invite only opportunities and you must work with an investment firm to get access to these.
Gold bullion or ETFs
Whilst gold does not provide a fixed income, it is a great way of preserving capital from the effects of inflation. It is the gold standard (pardon the pun). Alternativley you can look at gold ETFS on the ASX like GOLD.
High yield property
coming soon.
To learn more about private credit investments click here.
To speak to us about your investment options contact us here.
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