Negative interest rates on corporate deposits - a potential alternative — Dublin, Ireland

Interest rates have been tracking downwards for over a decade at this point. We are at a unique time in our history whereby banks have actually been charging certain depositors to hold their money on deposit. This is the case for money held within corporate deposits.

While paying for the privilege of lending money to banks goes against everything that we know, it actually still might be a price worth paying. The interest rate cost will be relatively low and it will enable the continued access to this money for working capital or investment purposes.

However, there are some companies that are in the enviable position to have excess cash reserves and where there is no reasonable short-term need for these funds. It may not make sense to leave these funds for years in a negative interest rate environment that slowly eats away at the principle.

The default alternative that has received a lot of commentary in recent times is to invest the money. However, going from a deposit account to investing in 100% equity is probably not desirable. Investing money is accompanied by a high level of volatility that may not be appropriate for the use of these funds. Investment products with exit penalties due to upfront commissions are also not suitable due to lack of flexibility.

Another option that has found favour with our clients is to hold a combination of short-term bonds with a small allocation to equities.

The rationale is as follows;

Maximise security
Keep investment costs low
Achieve a reasonable level of return by keeping up with inflation
Maintaining liquidity - funds can be accessed quickly if needed

We are suggesting a portfolio made up of the following:

80% short dated fixed interest bonds
20% global equities

What are short-term fixed interest bonds?

Short-term bonds as the name implies are short term in nature and are “rolled over” to new bonds once the term expires. By rolling over short-term debt frequently, any higher inflation and interest rate expectations will be priced into the new bonds thereby giving a degree of protection should inflation suddenly spike. Short-term bonds can be accessed through a fund. The fund invests in instruments issued by governments, corporates and supranational entities (cross border organisations such as the WTO and European Union are examples of supranational entities) which have low credit risk. Therefore, short-term bonds would be considered low risk.

Why invest in equities?

In order to drive a return, we recommend investing a small portion (20%) in global equities that have allocations to every open capital market in the world. The diversification benefit of holding both stocks and bonds means that very often they do not fall at the same time and by the same magnitude.

For illustrative purposes, the maximum one year drawdown of a 20/80 stock/bond portfolio was just 5.5% over the last 30 years.*

What level of return should I expect?

The return from bond funds has been very low over the last number of years in this low interest rate environment. However, while the European Central Bank still has a headline interest rate of 0% which essentially means negative interest rates for corporate savers, it is possible to earn a higher yield with very low risk bonds. For example, the yield on 5 year US Treasury Bonds is currently 0.89% and the yield on the Canadian 5 year bond is currently 0.84% (correct as of 17th June 2021).

Vanguard (one of the largest investment firms in the world) project median 10 year nominal annualised returns of 6.2% for equities and 1.2% for fixed income.** While any prediction comes with a large health warning, this would equate to a blended return of 2.2% before charges.

What taxes would be due?

There is a tax rate of 25% on investment income and capital gains within a corporate structure as opposed to the normal 12.5% on trading profits. There can also be an additional 20% close company surcharge if funds are not disbursed within 18 months from the company.

However, if the investments are made through a life assured investment product, i.e., using the well-known insurance companies, this surcharge is not applied to the investment gains. The investments are in a so-called “gross roll up” structure whereby the funds are not taxed each year but only on the 8th anniversary of the investment term (assuming they have not been drawn down in the meantime). It should be noted however that there is a 1% Government levy when monies are initially invested in a life assured contract.

Next Steps:

If you would like to learn more about this strategy, please contact myself at hughgallagher@pfp.ie or 01 4980007

*Figures based on simulated index data. The fixed income returns are based in the Euro Short Term rate/3 month Deutschemark rate and the equity returns are based on the MSCI World Index €

**Vanguard economic and market outlook for 2021: Approaching the new dawn. Date: December 2020