Fixed rate savings are an interesting beast. While they do not offer the long-term growth potential of over savings vehicles like mutual funds, stocks, and so on, they do offer a consistent rate of return over a fixed period of time. And after suffering through the stock market problems of 2007, 2008 and part of 2009, fixed rate savings offer something few other investments can — a principal guarantee (see “Risks” below).
The unattractive features of fixed rate savings are actually what allow investors to enjoy the benefits. For those reasons, this investment vehicle plays a vital role in any portfolio as a “cash” or “income” investment, depending on the type of savings you choose.
The benefits to fixed rate savings are that your principal is guaranteed by the bank or other issuer. Additional guarantees can come in the form of government insurance such as that offered by the FDIC in the United States, the FSCS in the UK and the CDIC in Canada (other governments will offer guarantees in their respective countries). With this type of additional insurance, depositors can rest assured that in the event of mass failures, their savings are safe to the maximums prescribed by each insurer.
The drawbacks to this vehicle of savings, however, are that they pay poorly compared to similar-risk investments. Therefore, establishing a long-term savings objective based purely on the rates offered by fixed rate vehicles as well as the lack of growth opportunities does not make a fixed rate vehicle very attractive. There is one exception, though, and that is if the investor is able to lock in a rate that exceeds the average future rate of inflation time and again, which is unlikely if not impossible.
Additional drawbacks include the fact that many higher-rate fixed rate vehicles are locked-in, meaning they cannot be cashed in prior to maturity. This is different from bonds which can be traded at market values at any time prior to their maturity date.
Contrary to what many people believe, there are risks to fixed rate savings, even with insurance. The worst-case scenario would involve all global financial institutions failing and the government-backed insurer being unable to raise capital to compensate all depositors who make a claim. While clearly a far-fetched scenario, remember that a lot of investors never believed that an insurer like AGF could fail, yet it came dangerously close to failure in 2008. Additional risks are that the depositor invests more than the maximum prescribed under the insurance policy, but such risks are considered controlled risks in that the depositor has the discretion to limit them.
Using fixed rate savings as part of an overall portfolio/investment strategy makes the most sense in almost every instance. Depending on the investors risk tolerance, long- and short-term investment horizon as well as their overall objective, fixed rate savings are normally a part of the low-risk or risk-free income-generation portion of the portfolio. However, since fixed rate savings traditionally offer lower rates than bonds and for the most part lack liquidity, many investors will choose bonds.
An interesting bond/fixed rate strategy would involve buying bonds until the rates on fixed rate investments increase, then cashing the bonds to invest at the guaranteed rate and guaranteed principal fixed rate investment. The problem with such an approach is that yields and bond prices are inversely related, meaning that as rates increase, the value of the bond decreases. For that reasons, only sophisticated and knowledge investors should rely on such a strategy.
Ultimately, fixed rate savings vehicles make the most sense when the investor is able to lock in at high rates for extended periods of time particularly in periods where inflation is decreasing or expected to decrease.