Here's a reason to stick with the big banks
Wednesday, 10 July 2019
OPINION: Interest rates on term deposits are the lowest they have been for decades and investors who rely on interest to provide an investment return are looking for alternatives.
With further cuts to the Official Cash Rate on the cards, the prospects for fixed interest investors look bleak.
We are on the brink of a global economic downturn. Lower economic growth in New Zealand could see increased unemployment and people struggling to pay the massive mortgages they have incurred with record high property prices.
We need to keep in mind that a key trigger for the Global Financial Crisis was a property crash in the United States. Little wonder then that the Reserve Bank is proposing to take steps to shore up the banking system with increased capital requirements and to stimulate the economy with interest rate cuts. These are prudent moves in what will be an uncertain few years.
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Safety and security should be of prime concern for investors in this environment.
The lessons learned as a result of the Global Financial Crisis in 2008 were hard. In the heady days prior, investors rushed to make the most of double-digit interest rates seemingly in ignorance of the financial risks that accompanied the high returns. The carnage that resulted from the collapse of finance companies led to many improvements in the supervision and regulation of our financial markets.
The stability of our financial markets is under the watchful eye of the Reserve Bank and Financial Markets Authority and the changes made over the last decade should stand us in good stead for the next economic downturn. One of the key changes was to make it mandatory for deposit-taking institutions to obtain and publish a credit rating from a reputable rating agency.
This means that investors are able to make informed decisions about the risk they are taking in relation to the return they receive.
However, it is one thing for financial institutions to publicise their credit rating. It is another thing for investors to inquire about credit ratings and to understand what they mean. Many investors didn't understand credit ratings prior to 2008 and they still don't.
A credit rating is an independent opinion of the capability and willingness of a financial institution or company to repay its debts. The rating is calculated as the likelihood of failure over a given period of time and is expressed alphabetically. A rating of AAA is extremely strong while a C rating denotes a high degree of vulnerability to non-payment. What many investors fail to understand that is risk increases exponentially as you move from AAA to C.
Credit ratings are in no way similar to the grading system we are familiar with from school days where C is a pass and A is outstanding. The Reserve Bank has a very useful publication titled 'Know your Credit Ratings' which is available to download from their website. Every investor should have a copy on hand. What this publication will tell you is that institutions with a rating of AAA have a one-in-600 chance of defaulting in a five-year period, while those with a BBB rating have a one-in-30 chance of defaulting in a five-year period. That's a massive difference in risk.
Let's take a closer look at ratings of New Zealand financial institutions. Our main banks – ANZ, ASB, BNZ and Westpac have an AA- rating. That's a probability of default of around one in 300 over five years. By comparison, Co-operative Bank, Heartland Bank and SBS Bank have a rating of BBB which reflects a one in 30 chance of default in five years.
Yet, let's compare the difference in return. The main banks with an AA- rating are currently offering between 3 per cent and 3.15 per cent for a three-year term deposit. Banks with a BBB rating are offering between 2.95 per cent and 3.4 per cent for three years. Investors in BBB-rated banks are taking on about ten times the risk for little or no additional return at a time when the economic outlook is uncertain.
Take it down a notch to a BB rating which is where Building Societies and Credit Unions sit and the probability of default is one in 10 over five years, yet the interest rates offered are not significantly different to those of the main banks.
Governor of the Reserve Bank Adrian Orr recently stated that the aim of the Reserve Bank cannot be to have a zero-risk financial market in New Zealand. It is simply not feasible to remove all risk and have a financial market that responds to market signals. The job of the Reserve Bank and the Financial Markets Authority is to ensure we have financial stabilityand fair, efficient and transparent markets. It is up to every investor to know and understand the financial risk they are taking and to make rational decisions based on that information.
Liz Koh is an authorised financial adviser and author of Your Money Personality; Unlock the Secret to a Rich and Happy Life, Awa Press. The advice given here is general and does not constitute specific advice to any person. A disclosure statement can be obtained free of charge by calling 0800 273 847.