Decrease in interest rate - Achieving high returns for savers amidst current market conditions
## Overview
- Savings Account
- Deposit Account
- Bonds
Central bank officials are known for their mathematical prowess, often focusing on discussions about inflation rates, economic growth, and interest rates expressed as percentages. Their private thoughts, however, are rarely shared. It was, therefore, unexpected when Christine Lagarde, the French leader of the European Central Bank (ECB), revealed her sleepless nights during a conference on monetary policy in October 2022.
To comprehend Lagarde's unease, it's important to recognize the primary role of the ECB: maintaining price stability. However, inflation had previously escalated well above 10% in the Eurozone, with the ECB aiming for a target of 2%. In response, the ECB had implemented significant interest rate hikes. When prices increase significantly, central banks typically counter with rising interest rates.
The hikes worked, and overall inflation in the entire currency union was only 2.6% in May. For Lagarde, the time for a rate cut seemed favorable. The savings interest rate designed for 4.0% would now be reduced to 3.75%.
But high interest rates can hinder investments, while savers can profit from them. Savings accounts and deposit accounts were again generating returns, thanks to bond yields at the capital market. This remained the case despite the lowered interest rate. "We don't anticipate the ECB will institute extensive and incremental interest rate cuts," predicts Ann-Katrin Petersen, a Capital Market Strategist at Blackrock Investment Institute. The era of low interest rates, which made bond investing so challenging in the last decade, is unlikely to return.
The optimism of economists and fund managers about interest rates stems from the substantial financing needs for the transition of the economy to climate neutrality and increasing military spending. Inflation rates may also need to remain high for structural reasons, such as population aging, labor shortages, and ultimately rising salaries.
Savers and investors should consider: For how long and for what reason will the money be invested? The appropriate yield product is then determined based on this information. This can range from a savings account, a deposit account, to a bond investment via a fund or an exchange-traded fund (ETF). Here's a look at your options.
Savings Accounts
The foundation of saving is a savings account. Being readily available for daily use, it's recommended as a financial buffer by protection organizations to cover unexpected expenses. Having between three and six times your net monthly income allocated to a savings account provides adequate liquidity. However, interest rates for savings accounts are quite low at many financial institutions, so it's worth comparing. If you have €10,000 and earn an extra one percentage point on interest, you'll gain an additional €100 per year (after taxes). That's enough for a family meal out.
Deposits are also protected by deposit insurance regulations up to €100,000 per customer and institution. These rules are enforceable across the European Union, ensuring that deposits in other countries are safe in the event of a bank failure. If you prefer the security of German deposit insurance, there are still attractive deposit deals available.
For example, the savings account with a 4.0% interest rate from neobroker Trade Republic, which lowered its offer to 3.75% following the ECB's interest rate cut, is popular. Bank11, Santander, and Comdirect offer similar deals. However, it depends on the duration of the investment and the amount involved. Comparison shopping is always recommended.
The cap on the maximum limit is connected to the ECB's interest rate. Banks can place money with the central bank overnight if necessary. Banks would have to pay interest to their depositors if they offered more than 3.75%. Therefore, deposit rates for savings accounts are likely to drop even further after more ECB interest rate cuts.
Savings Accounts
If an individual wants to lock in current interest rates for a longer period, they should consider savings accounts or capital market investments. "For short-term investments up to one year, savings accounts are the optimal choice," advises Reinhard Pfingsten, Chief Investment Strategist of the German Doctors' and Pharmacists' Bank. These are time-bound savings products with two advantages: the money, along with interest, is available at maturity. This allows for more predictability regarding large purchases, trips, or mortgage payments. Investing €5,000 at a 3.5% interest rate for three years ensures receipt of €5,543 at the end of the term.
Unlike capital market products, there are typically no fees or trading costs with savings accounts.
If you're thinking about investing your money for a year with the German deposit insurance, there are some attractive options available. Biallo, a comparison portal, states that you can earn up to 3.8% interest through SBI Frankfurt, the German branch of the Indian state bank. Volkswagen Bank offers 3.3%, and Cronbank offers 3.25%. Before making a decision, it's essential to consider factors beyond the interest rate, such as the ease of opening an account and the creditworthiness of the institution.
For those considering investing abroad, options include Klarna in Sweden, which offers a 3.51% interest rate, and Stellantis Direct Bank in France, with a 3.5% rate. The Bigbank in Estonia offers an even higher rate of 3.55%.
The trend of low base interest rates means that these savings account rates may soon become obsolete. Reinhard Pfingsten from the German Doctors' and Pharmacists' Bank notes that as the ECB is expected to further decrease interest rates in the second half of the year, investors will face challenges when reinvesting.
An alternative to savings accounts is investing in bonds. Despite falling base interest rates, the bond market is making a comeback. Bonds, also known as bonds, have a fixed term and regularly pay interest known as coupons. Governments and companies are the issuers.
The issuers of bonds, such as Germany, France, and the US, offer different yields. German government bonds with a maturity of ten years pay around 2.5%, France pays around 3.0%, and the US pays 4.3%. However, US bonds, also known as Treasuries, involve currency risk since they are denominated in dollars.
Experts like Smadar Shulman, bond expert at S&P Dow Jones Indices, and Philippe Berthelot, Head of Bond Markets at the Asset Management Company Ostrum, agree that the bond market is very appealing to people with savings. Bonds offer regular income and, if held until maturity, come without the market risk associated with stocks.
It's crucial to remember that bond prices can fluctuate before maturity. This happens because the yield of securities adjusts to current market interest rates. If market interest rates fall, bond prices rise – and vice versa. This creates additional revenue opportunities but also comes with more risk.
Investing in long-term corporate bonds with good credit quality may yield an average return of 4%. For risk-tolerant investors, corporate bonds from emerging markets and high-yield bonds can serve as a supplement. High-yield bonds come with higher risks, but they offset this with higher returns. The same applies to bonds from emerging markets, which carry the added risk of currency fluctuations. In 2022, a basket of Euro high-yield bonds and Euro-denominated bonds from emerging markets had a double-digit return.
When it comes to bonds, like any other capital market investment, fluctuating prices are possible. Therefore, investors should consider spreading the risk by buying a fund that invests in numerous securities rather than individual bonds. These funds can be managed actively or follow a passive index, like the Bloomberg Barclays Global Aggregate Index, which is recommended for a global bond portfolio. Index funds, also called Exchange Traded Funds (ETFs), are cheaper but lack the ability of a management team to intervene in any problematic issuers.
Bond funds are well-suited for long-term investment and wealth accumulation. For shorter maturities or fixed payment obligations, savings and money market funds are recommended. BlackRock offers a unique solution with its iBonds-ETF, which combines both investment forms. iBonds are ETFs with a fixed maturity date and contain only corporate bonds with similar repayment dates. The yield of iBonds resembles that of savings accounts, but they also offer the advantage of being daily tradable on the stock exchange.
As with any interest product, the final decision rests with the ECB Governing Council, led by Christine Lagarde, whose decision on the interest rate will ultimately determine the rates offered.
To sum up, various options exist for people wanting to invest their money for a year, with rates ranging from 3.25% to 3.8% for German deposit insurance institutions. Alternatively, if you're open to investing abroad, you can find attractive rates in Sweden and France. If you prefer a long-term investment option with regular income, bonds might be worth considering, even though they carry more risk due to fluctuating prices. Investing in bond funds is a sound choice for spreading the risk and achieving a higher return. The European Central Bank's governing council's interest rate decision will ultimately determine the rates on offer.
