Deposits rate warning for investors

Feb 3 2010 By Andrew Miller, The Journal

NEW investors will need reminding that cash deposit rates are still at very low levels by historical standards. But a renewed recession - something which could help trigger renewed "safe haven" demand for cash - looks unlikely.

Because of this and the paltry returns on offer, we have a bias against cash in our global multi-asset investment portfolio. Many investors hold their cash deposits in AA-rated banks, which are either implicitly or explicitly guaranteed by the Government, and consequently offer low yields. Investors can however enhance their yield over cash rates by taking on interest-rate risk, credit risk, mark-to-market risk (i.e. the risk that the market price of an asset may deviate substantially from its "fair value"), or illiquidity risk - or some mix of the above.

Currently, bond markets suggest that interest rates will be higher by the end of this year; while some investors may well be hoping that their deposit rates may also increase, they should note that in an environment where central banks are confident enough to start raising rates, returns on cash tend to be lower than those from equities or corporate bonds.

Meanwhile, government bonds look likely to suffer as rates rise, and although we expect the movements in yields to be broadly similar regardless of maturity, we would be wary of long-end government bonds because of their high sensitivity to expected interest rates, as well as the probability of heavy new issuance (something we have highlighted in previous columns). We therefore suggest that if investors wish to enhance yield, they should still maintain a focus on the 2-3 years maturity range.

However, the overall pick-up in yield from investing in short-term government bonds is not that great, and investors can achieve noticeably higher yields via the corporate bonds of high-quality (i.e. investment-grade) issuers. The yields on corporate bonds are still quite attractive, especially compared to cash yields, and shorter-dated corporate bonds could be held to maturity without causing investors too many sleepless nights. Lower-rated bonds look even more attractive from a yield perspective, but they require very careful screening as credit risk (or the risk of the issuer defaulting) is considerably higher. Additionally, high-yield bonds (and even some investment-grade bonds) are illiquid (i.e. not easily converted to cash) and thus not suitable for investors who need the flexibility to exit their investment at any point.

As an aside, our outlook for business confidence and profitability in 2010, along with undemanding valuations in developed market, leads us to an overweight equities position in our portfolio. However, investors currently holding cash may be wary of investing in equities because of the mark-to-market risk and the possibility of losing all their investment if markets take a tumble. Liquidity is less of a problem in equities than in corporate bonds.

We believe the journey out of cash should involve making allocations to investment-grade bonds, high-yield bonds and equities - allowing for investors' risk appetite for such investments, of course. Always remember that with these investments you can lose money as well as gain.

Andrew Miller is Newcastle office head at Barclays Wealth