In our conversations with people, and during the seminars that we present, we find that most people in New Zealand are under the mis-understanding that their Term Deposit investments with NZ banks are 'safe'.
There are three factors to consider when deciding whether these investments are 'safe'.
1.Investment Volatility
When compared to the risk and return of equities (shares), listed property, residential property, foreign exchange, commodities, options, derivative
s, then yes, as a 'Tier One' investments, Term Deposits are 'safer'. There is little chance of the value of these investments going up and down like the more volatile investments listed here.
2.Keeping up with inflation
Will this investment retain your 'purchasing power'? Traditionally, term deposits only just keep track with inflation rates. So, as prices increase over time, your term deposit will usually just keep up with inflation (after tax). Sometimes, when inflation is low, you might get a 'real' return - that is you actually get a return after tax and inflation from term deposits. But remember, when interest rates are much higher (like when they used to be 6% or more), this generally reflects that fact that inflation is also higher. So, although you might be able to sleep at night because the value of your investment isn't going up and down in value, you could be losing your ability to buy things, and retain your standard of living.
3. Ability to repay your money
When you take out a term deposit with a financial institution, you are 'lending them your money'. They will then use your money to make money for themselves. Simplistically, they will then lend it out to someone else on a mortgage, and make 1-4% extra along the way, depending on what the average lending cost they can get is. In more detail, they use the funds to lend to a range of borrowers, but as we know from profit announcements, the banks are extremely good at making money.
Remember, Term Deposits in New Zealand financial institutions are not Government Guaranteed.
But how can you tell if they can repay your money? The key shortcut to working this out is looking at the credit ratings of the institution that you are 'lending'/investing your funds with. At Moneyworks, we recommend our clients to only make term deposits with institutions with an A in their credit rating. As a reminder, the Credit Ratings show how 'safe' an institution is, how likely they are to repay your money. The more letters that an institution has, the better. Therefore AAA is better than A, which is way better than BBB. Each of these letters then has a + or a -. Obviously a + is better than nothing, which is then better than a -. Therefore, a AA- credit rating is significantly better than a BBB+. For more information on Credit Ratings, check out the following blog articles:
What happens if a financial institution does get into financial difficulty? The Open Bank Resolution
The New Zealand Government doesn't guarantee deposits in banks. But the Open Bank Resolution (OBR) policy gives depositors some protection if a bank gets into trouble. For more information,look at the Reserve Bank of New Zealand's website. But here is some of the most relevant information:
'Under OBR, if a bank fails, it can be reopened the next day under statutory management. Customers have immediate access to most of their money. Under OBR, this money will be government guaranteed.
If a bank fails, it is placed under statutory management and closed. An assessment is made of the bank’s liabilities. If losses cannot be covered by shareholders and the bank’s available capital, then in addition a proportion of depositors’ funds are set aside and frozen for the purpose.
The bank re-opens next morning. Depositors can then access most of the money in their transaction and on-call savings accounts and conduct their normal business. How much of their funds depositors can access will be determined by an assessment of the bank’s losses, and the amount, known as a de minimis, which is intended to enable depositors to conduct their daily transactions.'
This is what is colloquially called a 'haircut'. How much of your funds you will lose will depend on how dire the situation is in the financial institution. You might also get the money back eventually. 'Depositors will still have a legal claim to their frozen funds as unsecured creditors, and if any money can be returned to depositors after the bank's financial situation has been worked through, it will be.'
Summary
It is important that you understand that your term deposits are not guaranteed. That you could lose funds if the lending institution got into trouble. It is important that you understand how Credit Ratings work. It is important that you understand that you are likely to lose 'purchasing power' if you keep all your investments in term deposits.
Remember the keys to success in financial planning:
- Diversification - don't put all your eggs in one basket
- If it looks too good to be true, it usually is
- The higher the return, it usually means it is higher risk.
If you have any thoughts or opinions that you would like to share, visit us at our Twitter, Facebook or Linked In pages, and comment.
For more blog entries that you might be interested in:
Warren Buffet Investment Quotes
Bubble-ology – Context and pedigree are vital
How to get the most out of your term deposits
By Carey Church
