Wealth Management
Capital Preservation and Fixed Income
Capital preservation is often cited as a core motivation for fixed term investing. This article examines what capital preservation means in practice, and the limits of what fixed income can offer.
Executive Summary
Capital preservation — the objective of protecting the nominal or real value of invested capital — is frequently cited by investors as a primary motivation for allocating to fixed term products. However, the term is often used loosely, and it is worth examining precisely what capital preservation can and cannot mean in the context of different fixed income and fixed term structures. This article explores the concept, distinguishes between nominal and real capital preservation, and considers where fixed term investments fit within a broader capital preservation strategy.
As with other topics in this series, the discussion here is general in nature. Capital preservation strategies should be considered in light of an investor's specific circumstances, objectives and risk tolerance, ideally with the assistance of professional advice.
Nominal versus Real Capital Preservation
Nominal capital preservation refers to the return of the original dollar amount invested, without regard to changes in purchasing power over the investment term. Real capital preservation, by contrast, accounts for inflation, meaning that the invested capital retains its purchasing power over time. A fixed term deposit that returns 100% of the invested principal at maturity has achieved nominal capital preservation. However, if inflation over that period has exceeded the interest earned, the real value of that capital — its purchasing power — may have declined, even though no nominal loss occurred.
Preserving the number on the statement is not the same as preserving what that number can actually buy.
Where Fixed Term Products Fit
Term deposits with Australian ADIs are often regarded by investors as being towards the more conservative end of the risk spectrum for nominal capital preservation, given the presence of the Financial Claims Scheme, which protects eligible deposits up to $250,000 per account holder per ADI in the event of an ADI failure. It is important to be precise about what this protection covers: the FCS applies to deposits, not to bonds, notes or other securities, even where those instruments are marketed using similar 'fixed term' language. The FCS is also not a general government guarantee of an institution's ongoing solvency or performance — it is a specific scheme with defined eligibility criteria and caps.
- ADI term deposits: potential FCS coverage up to $250,000 per account holder per ADI; amounts above this threshold are not protected by the scheme.
- Government bonds: generally regarded as lower credit risk given sovereign backing, but not covered by the FCS and subject to market price fluctuation if sold before maturity.
- Corporate bonds and notes: subject to issuer-specific credit risk, with no FCS coverage; capital preservation depends on the issuer meeting its obligations.
- Diversification across institutions and issuers can help manage the concentration of capital preservation risk in a single counterparty.
The Limits of Capital Preservation
It is important for investors to recognise that no fixed term or fixed income product offers a guarantee against loss in an absolute sense. Even within the FCS framework, protection is capped per account holder per ADI, meaning that balances above the threshold, or funds held with non-ADI entities, do not receive the same protection. Corporate bonds and notes carry the risk that the issuer may fail to meet interest or principal repayment obligations, a risk that varies significantly depending on the issuer's credit quality. Inflation, as discussed above, represents a further and more subtle threat to capital preservation, since it can erode purchasing power even where nominal amounts are fully returned.
Key Considerations for Investors
- Distinguish between nominal capital preservation and real, inflation-adjusted capital preservation when evaluating a product.
- Understand the specific protections attached to a product, including whether it is FCS-eligible or not.
- Diversify across institutions and issuers where capital exceeds relevant protection thresholds.
- Recognise that higher stated rates may reflect additional credit or structural risk, rather than superior capital preservation.
- Factor inflation expectations into assessments of whether a given rate meaningfully preserves purchasing power.
Conclusion
Capital preservation is a nuanced objective that extends beyond simply receiving back the dollar amount originally invested. Understanding the distinction between nominal and real preservation, and being precise about which protections apply to a given product, can help investors set realistic expectations for the role fixed term investments play in protecting capital. This article is general information only and does not constitute personal financial advice.
Related topics
Information contained within these insights is provided for general information purposes only and does not constitute personal financial advice, an offer or recommendation to acquire or dispose of any financial product. Investors should consider their individual circumstances and obtain appropriate professional advice before making investment decisions.
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