Mother in law's guide: Opt for 6-18 months in guaranteed deposits (Updated)

(Updated on April 8 to include latest savings rate increases and 'What's hot right now' section) By Bernard Hickey Here's the short version. Interest rates are near the bottom of their precipitous fall since the middle of last year. Investors wanting higher interest rates are now seeing higher long term rates for deposits and debentures, but rates will rise further yet. In the meantime, the best thing for the risk averse investor to do is to hunt for the best short term rates on offer by guaranteed, investment grade financial institutions and to watch closely what the government is saying about how to extend, replace or remove the retail deposit guarantee. The long version. Sometimes my 60-something mother-in-law (I dare not ask her age) quizzes me about what she should do with her cash savings. Like many other New Zealanders, she and my father-in-law live in their own mortgage-free home and supplement their pensions with the returns from these savings. My mother-in-law is very risk averse, but would like as high a return as possible. My comments below should be taken as what I would tell my mother-in-law generally about the outlook for interest rates and what's on offer now rather than any sort of specific financial advice. Every person is different with different appetites for risk and different personal situations. The outlook for interest rates is uncertain at the best of times, but the global and New Zealand economies are entering a particularly volatile and pivotal period where interest rates appear to be bottoming out and are likely to bounce over the next year or two, particularly for long term rates. One reason it's pivotal is that the yield curve, which shows the various interest rates over various periods, is expected to pivot and become even more positive. That means longer term interest rates are expected to rise while shorter term rates are likely to stay relatively low for at least the next six months or so. Very short term rates may even fall a bit more in New Zealand as the Reserve Bank cuts the Official Cash Rate to 2.5% by the middle of 2009 from 3% now. Expectations of weak economic growth globally through 2009 are likely to keep the short term interest rates set by Reserve Banks at low levels as they battle to get their economies going again. However, long term interest rates, which are governed more by supply and demand in the market than what central bank governors do or say, have already started rising and will rise further. That's because governments globally, including our own, are embarking on massive borrowing to fund budget deficit spending to revive their economies. US President Barack Obama is expecting to borrow US$4.5 trillion over the next four years to finance huge deficits. That's almost 25% of GDP. This wave of new debt about to hit the global bond market is so enormous it has pushed up the US 10 year bond yield from 2% to 3% in the last three months. Also, central banks in Britain and America are printing money hand over fist. This will create inflation in a couple of years time unless these central bankers are very clever and turn off the petrol pump just before the economy catches fire. Many are sceptical. Even our Reserve Bank Governor Alan Bollard believes the global economy faces a "very nasty" inflation problem in a couple of years time. This means longer term interest rates will rise over the next year or two. It may make sense to park your money in an account with a reasonable yield before jumping in once longer term rates have risen to lock in a higher yield. Watch the government guarantee A crucial element for any saver in New Zealand right now is the government's retail deposit guarantee. The guarantee completely changed the risk and return equation at the stroke of a pen in the second week of October last year. The danger, of course, is that another stroke of the pen could change it back again. The scheme's fate is in the hands of bureaucrats and politicians. The government had no choice but to announce a government guarantee for retail deposits (up to NZ$1 million) in banks, building societies and finance companies. Australia was about to do the same thing and the consequences of not offering the guarantee at a time of unprecedented turmoil in global banking would have been unthinkable. But it has been a blunt instrument and it will have to be replaced, extended or removed. It is a crucial factor for anyone making a decision about where to invest. Term deposit rates fell quickly soon after the introduction of the guarantee, particularly for finance companies that didn't have to offer such high rates any more to encourage investment. Many finance companies also filled their coffers quite quickly in the few weeks after the introduction of the guarantee and didn't have as many attractive places to lend that money out. This was another reason why finance companies cut their rates. So what next with the guarantee? Some in the financial industry expect the guarantee to be extended a year to ensure its expiry matches the three year guarantee put in place in Australia. But beyond that a clear direction has yet to emerge from government. Finance Minister Bill English has said he does not want the government to be stuck guaranteeing large amounts of finance company deposits for a long time, particularly in the wake of the receivership of Mascot Finance, which had been troubled before it was granted the guarantee. One option is to extend it indefinitely and introduce a fee-based system where riskier institutions pay a higher fee to the government in exchange for the guarantee or for deposit insurance. Another option is to drop the guarantee and return to the previous plan for all deposit taking institutions to have a credit rating and to be forced to have certain capital levels by the new regulator, the Reserve Bank. Whatever happens, investors need to watch this space and to make any decision with the current October 2010 expiry date in mind. If the maturity of the term deposit or debenture is after October 2010 and you think the institution is riskier than the return you're getting then don't invest. Avoid the junk I'm telling my mother-in-law to avoid investing in any institution that doesn't have an investment grade credit rating (BBB minus or better), regardless of whether the deposit is within the guarantee period or not. Moody's is now saying that the risks globally of sub-investment grade debt (or junk as some call such debt) defaulting in the next year is around 17%, which is higher than it has been since the Great Depression of the 1930s. My view is that the New Zealand economy is in for a long, but not extremely deep recession that will trigger more corporate defaults and keep the property market depressed for the next couple of years. More property developers and property investors will default on loans from finance companies and banks. The major banks and the investment grade-rated finance companies are robust enough, have diversified funding, diversified lending, strong shareholders and are conservative enough to avoid life threatening experiences. This relatively short list includes the big four Australian-owned banks, Rabobank, Kiwibank, TSB, Marac Finance, South Canterbury Finance and UDC. Other less well diversified or lower rated financial institutions will struggle. I'm telling my mother-in-law not to invest in junk-rated institutions (worse than BBB minus) that are exposed in any way to the property market, regardless of the length of the government guarantee or its replacement. Some may choose to invest in un-rated or junk rated finance companies or building societies, but they should demand very, very high returns, particularly for any period beyond October 2010. Any return less than 15% for this type of debt doesn't reflect the risk involved. What about these corporate bonds? Corporate bonds are another type of investment being promoted at the moment. Over NZ$2.6 billion has been invested in these bonds in the last 6 months by small investors and fund managers. Interest rates ranged from 6% to 9% for 5 year periods were offered by companies with a variety of credit ratings. They did not carry government guarantees. I would have said to my mother-in-law that any investment for such a long period without a guarantee carried a lot of risk that wasn't reflected in the returns offered. Here's the full corporate bond rush list. An extra level of expertise is required to invest in a corporate bond, given any investor really has to understand the company's industry, it's performance, any regulatory issues and the structure of its balance sheet. It could be said any investor in a financial institution should know the same things, but at least the guarantee, Reserve Bank supervision and a strong credit rating offer some protection. I would tell my mother-in-law to get a lot of advice before investing and to demand at least 9% for even the investment-grade bonds. What time period? My core view is that long term interest rates will rise over the next year because of the weight of new government bond supply coming onto the global capital markets and the inflationary pressures created by mass money printing. It makes sense therefore to find a shortish term investment for 6 months to 18 months that allows an investor to roll off late in 2009 or through to mid 2010 onto a higher rate. My mother-in-law might not like this prospect from a pure yield point of view right now. The highest interest rates being offered by guaranteed investment grade institutions are around 4% to 5% right now. See all the rates beyond one year here. But accepting a lower yield now is a better option than taking a punt that a junk-rated institution will be around in three or four years, that the guarantee might be extended, and that interest rates will stay low. It wouldn't surprise me to find interest rates for longer term deposits and debentures rise above 7% again by the end of 2010 and by then we will all know a lot more about the future of the government guarantee and the global inflation outlook. But the key thing is I will still be in my mother-in-law's good books because she has not lost money or sleep! What's hot right now See all the latest rates up to 12 months here and all the rates beyond 12 months here) The highest rates from the guaranteed banks and others in that 6-18 month range are around 4.5% for 12 months for ANZ, National, ASB and Westpac. Kiwibank has a 12 month special of 4.6% with payment on maturity. ASB and BankDirect have 4.75% for 18 months. There is then a step up to around 5.25% for 2 years for most of the big banks and a rise to 6% for five year term deposits. I think those long term rates have some way to rise in the next 12 to 18 months so it would pay to wait before locking in.