The “good news” for term deposit investors is that interest rates have probably bottomed. And that’s despite the best efforts of RBA Governor Philip Lowe, who keeps reminding the market that the RBA won’t increase the cash rate “until 2024 at the earliest”.

Last week’s “dot plot” from the US Federal Reserve suggested that a majority of the 18 Governors who make up the FOMC (the key US interest rate setting committee) now expect the first interest rate increase to be in 2023 (0.5% in total). Canada and New Zealand have  started to move rates higher, so there are signs the interest rate cycle is turning.

However, because Governor Lowe wants to see sustained wages growth in the order of 4% to 5%, rates remain on hold in Australia at next to 0%. While I expect Governor Lowe will change his tune before 2024, I don’t think it will be anytime soon.

So, term deposit investors will need to go up the risk curve if they want to get a higher return.

Don’t get me wrong about term deposits. For retail investors, they should be part of  portfolios because they are “government guaranteed investments” on up to $250,000 per investor per financial institution. Effectively “risk free”, but paying a positive return.

But there is also a role for “riskier” investments, particularly if income is the main goal.

Risk means that you could lose some or all of your capital. It also means that there is more volatility in the “market price” of the investment.

1. Here are 4 ASX listed riskier alternatives to term deposits. These are ordered by “riskiness” (my assessment, from least risky to most risky, and excludes growth assets such as shares and property).
2. Secure fixed interest – investment grade bonds and funds
3. Risky fixed interest – bank hybrids
4. Diversified global infrastructure
5. Risky fixed interest – credit funds

1. Secure fixed interest – investment grade bonds and funds

The biggest borrower in Australia is the Federal Government who issues Treasury Bonds. After that you have the States, our major banks, and large corporations.

With the Reserve Bank acting in the secondary market to target a 3-year government bond yield of just 0.10%, treasury bonds are relatively unattractive. Longer  term bond yields have risen over the last few months, with 5-year bonds yielding 0.83% and the 10-year bonds  1.60%.

State Governments pay a little bit more, banks more again and corporations – it depends on their creditworthiness. Suffice to say, there is not much on offer of investment grade quality yielding over 2.0%.

To get any return, you will need to go up the credit curve (take on more credit risk) or buy longer term bonds (which increases interest rate or duration risk).

You can of course buy individual bonds through fixed interest brokers (these often will not be investment grade or “secure”), but it is hard (but not impossible) to get a diversified portfolio.

A relatively easy option is to consider a couple of the fixed interest exchange traded funds (ETFs). I prefer the ones of shorter duration and that take on a little more credit risk – so iShares Core Composite Bond ETF (ASX: IAF) or Vanguard’s Australian Fixed Interest Index Fund (ASX: VAF) would be my pick. They are yielding around 1.10%, and because they have holdings in bonds that were issued with higher coupons, running yields of around 2.6%.

Blackrock’s iShares has an ETF that tracks an index of investment grade corporate bonds. Under ASX code ICOR, the iShares Core Corporate Bond ETF has a yield to maturity of 1.31% and a current running yield of 2.99%. Vanguard’s  Australian Corporate Fixed Interest ETF (VACF) is similar to ICOR and has a yield to maturity of 1.35% and running yield of 3.09%. The duration on both these funds is around 4.0 years, which compares to around 6.0 years for IAF or VAF above.

Be wary of the terminology when it comes to fixed interest. If you are a holder to maturity, the only metric that really counts when comparing bonds of the same term is ‘yield to maturity’. Terms such as ‘running yield’ can be quite deceptive.

‘Running yield’ is an estimate of the next year’s income return, but if the bond is trading at a premium to its face value of $100, there will be a capital loss. If you pay $105 for a bond, you only get $100 back  when it matures – you need to factor in the $5 capital loss. This also applies to a fixed interest fund which has a running yield in excess of its yield to maturity – the capital price of the fund will decline.

2. Risky fixed interest – bank hybrids

I categorise bank hybrid securities as “risky” fixed interest because if the bank gets into serious trouble, you will probably lose about 80% of your capital. Some people refer to hybrids as ‘equities’ because they form part of the bank’s capital, but unlike normal shares,  they have absolutely no upside. You will never get more than your $100 back.

They are complex instruments – so  if you do not understand them or don’t want to understand them, don’t invest in them. ASIC’s MoneySmart website https://moneysmart.gov.au/investments-paying-interest/hybrid-securities-and-notes can help here.

One way to access the market and obtain a diversified portfolio is through Betashares Active Australian Hybrids Fund (ASX: HBRD). This is managed by Christopher Joye’s Coolabah Capital. The downside is the management fee of 0.55% pa.

If you do buy individual hybrid securities, try to build a diversified portfolio with multiple issuers. Here are some points to note:

• It is a classic “supply/demand” market. At the moment, demand is strong so prices are not far from all-time highs. If new supply emerges (such as the currently open offer for ANZ Capital Notes 6), prices in the secondary market will ease;
• You should assume (with bank hybrids) that it will be called (that is, redeemed by the issuer for $100) on the first available call date;
• If you are going to hold to maturity (the call date), look at the ‘trading margin” when comparing hybrid A to hybrid B. Running yield is pretty meaningless;
• You only get 70% of the coupon (they are expressed as “grossed up” rates that include the benefit of franking credits); and
• Current yields (including franking) are around 3.0% (plus the 90-day bank bill of 0.05%).

The ANZ Capital Notes 6 offer closes on 30 June. ANZ shareholders and securityholders can apply at https://www.anz.com/shareholder/centre/ The notes pay a fixed margin of 3.0% over the 90 day bank bill rate. ANZ can call the notes on 20/3/28, and they have a mandatory conversion date of 20/9/30. ASX listing under the code ANZPI is expected on 9 July.

3. Diversified infrastructure funds

Infrastructure is an asset class that has both growth and income characteristics. If investing in specific infrastructure stocks such as Sydney Airport (SYD) or toll road operator Transurban (TCL), you are arguably taking on more equity risk than income risk. If you invest in a portfolio of infrastructure stocks, some of the specific equity risk will be diversified away.

Because Australia only has a handful of large, listed infrastructure companies, these portfolios are typically global in orientation. Three of the larger ASX listed stocks which provide access to a portfolio of global infrastructure companies are:

• Argo Global Listed Infrastructure (ALI)
• Magellan Infrastructure Fund (Currency Hedged) (MICH)
• Vanguard Global Infrastructure Index ETF (VBLD)

Argo (ALI) and Magellan (MICH) are actively managed, whereas VBLD is a low-cost ETF passively tracking a benchmark index (the FTSE Developed Core Infrastructure). MICH  invests in a portfolio of 20 to 40 infrastructure stocks and hedges the currency risk. ALI uses Cohen & Steers from New York to manage the portfolio, which ranges from 50 to 100 individual securities. The currency exposure is not hedged.

Dividend or distribution yields for these three stocks are in the order of 3.0% pa to 4.5% pa.

MICH and VBLD employ the open-ended quoted fund structure and the price at which units trade on the ASX should be very close to their underlying NTA (net tangible asset value). ALI  is a listed investment company and is currently trading at a discount to NTA of around 11.0%.

These are long term investments, so your investment time frame should also be long. If interest rates go up at some stage, these stocks are likely to be impacted.

4. Risky fixed interest – credit funds

The listed credit funds got hammered in the Covid-19 market meltdown last year, down about 40% to 45% in price terms at their lows. They moved from trading at a small premium to NTA into steep discounts, as investors flocked to safety and credit spreads widened.

As the market recovered and credit spreads tightened, they rallied back to pre-Covid levels. Discounts to NTAs narrowed, with some even moving back to a small  premium.

There are eight listed credit funds. These are:

• Qualitas Real Estate Income Fund – (ASX Code: QRI)
• MCP Master Income Trust – (ASX: MXT)
• MCP Income Opportunities Trust (ASX: MOT)
• Gryphon Capital Income Trust – (ASX: GCI)
• Neuberger Berman Global Corporate Income Trust – (ASX: NBI)
• KKR Credit Income Fund (ASX: KKC)
• Perpetual Credit Income Fund (ASX: PCI)
• Partner Group Global Income Fund (ASX: PGG)

These are diversified funds investing in developer senior and mezzanine loans, corporate loans, residential mortgages and global high yield bonds.  Most pay monthly interest, targeting around 4% to 6%pa.

These credit funds are definitely “higher risk”. This means that it is really important to understand what the fund is investing in, the duration of those investments, the level of diversification, the domicile, and the underlying liquidity of those investments. Typically, corporate loans, mortgages and developer loans are not liquid.

Finally, a word to the wise. If you are investing in any security or fund that pays a higher return than a government guaranteed term deposit, then you are automatically taking on a riskier investment. This means that the likelihood of losses has increased, and in many cases, should be expected.

Two golden rules. Firstly, never invest in something that you don’t understand. Read the Product Disclosure Statement or Information Memorandum thoroughly, and don’t be afraid to ask the promoter questions. There is no such thing as a dumb question when it comes to investing your own money. If you aren’t satisfied with the answers, don’t invest.

Secondly, invest in moderation. The adage “don’t put all your eggs in the one basket” survives for a good reason. The riskier the investment, the less you should consider investing. Diversify across product, manager/issuer, security and asset class.