Investors sitting on cash have faced a dilemma in recent years. They could choose stable, low-risk options and accept near–zero per cent interest rates, or take more risk to try to generate higher yield. Faced with this unpleasant choice, many have opted to do nothing. But rates on many lower-risk options, including fixed deposits, money markets, and short-duration bonds, have moved up meaningfully in the last year. So, if you have been on the sidelines, you may want to reconsider, according to www.fidelity.com.
According to the Vice President, Fixed-Income Products and Services at Fidelity, Richard Carter, many people may be leaving money on the table by not taking full advantage of the cash portion of their portfolios.
If you are one of them, you should consider your options for cash, including high-yield savings accounts, short-duration bonds, and fixed deposit. While each of these options has advantages and disadvantages, Carter thinks fixed deposits are worth a careful look now, thanks to the variety of maturities and the appealing blend of relative safety, liquidity and yield.
Fixed deposits are time deposit accounts issued by banks in a range of maturities, from as short as one month to as long as 20 years. In buying a fixed deposit, you are agreeing to leave your money in the account for a specified period of time. In return for locking up your money for that period of time, the bank pays a rate of interest.
What does that extra yield translate to? Let’s say you invested N100,000 in a three-month fixed deposit with a yield of 1.2 per cent. Over the course of the three months, you would earn N299 in interest. Savers willing to lose a bit of liquidity and accept a bit of rate risk could buy a three- or five-year fixed deposit to get additional yield.
Access to your cash
The main limitation on fixed deposit relates to liquidity, or the ability to access your money. If you need to get your money back before maturity, traditional bank fixed deposits often charge a penalty that will reduce your yield and often reduce your principal.
The ladder strategy
Investing in fixed deposit involves a trade-off between yield and liquidity. The longer a fixed deposit’s term, the higher its yield is likely to be, but the more time you will have to wait to receive your principal. A laddering strategy can help you balance your need for liquidity and yield. It can allow you to take advantage of the higher yields available on longer-term fixed deposit while managing the additional liquidity risk by also investing in shorter-term fixed deposits that will mature earlier.
A typical fixed deposit ladder consists of several different rungs, each representing a fixed deposit with a different maturity. For example, you built a ladder that includes fixed deposits with maturities of three months, six months, nine months, and one year. After three months, the first fixed deposit has reached maturity and each subsequent fixed deposit has moved down one rung on the maturity ladder (the fixed deposit that initially had a six-month maturity has three months remaining; the nine-month fixed deposit has six months until maturity and so on). You can then take the principal from the first maturing fixed deposit, keep the interest, and rebuild your ladder by reinvesting the principal in a one-year fixed deposit.
In less than a year, all the original rungs with maturities of less than one year will have matured and been replaced by fixed deposits that pay the full one-year rate.
“Rather than choosing whether to pick liquidity or yield, you can choose a balance of both,” says Carter. “A fixed deposit ladder offers a way to have some of the benefits of both shorter-term and longer-term investments.”
The regular maturation and reinvestment of the fixed deposits mean that your portfolio will reflect changes in interest rates. If rates were to fall, you would begin to feel the impact of that. But if rates increase, you would be able to take advantage once the next fixed deposit on the ladder matures.
Questions to ask before investing in fixed deposit
How much cash do you need? Carter suggests thinking of a fixed deposit allocation as a middle ground between your investments and the highly liquid cash investments that you may need for daily expenses or to handle an emergency, according to www.fidelity.com.
What are your cash-flow needs? Answering this question will help determine the frequency with which you would like to see your fixed deposits revert to cash. When a fixed deposit matures, it will provide you with an opportunity to re-evaluate your cash needs and investment opportunities before reinvesting in a new fixed deposit.
How much liquidity risk can you take? Longer-maturity fixed deposits generally offer more yield, but come at the cost of liquidity – you may need to pay a penalty to access your money before maturity. So, you need to figure out how much liquidity risk you can take to determine the maturity of the final rung of your fixed deposit ladder.
The bottom line
The right cash management strategy for you will depend on several factors, from your current financial situation to your short- and long-term financial goals. Taking full advantage of your investment options – including fixed deposits and strategies such as ladders – may enhance your returns over time. “Right now, people may be missing out by not taking advantage of their options,” says Carter. “A fixed deposit ladder could help them earn more by making their cash work harder for them.”