Products in a low interest rate environment - Part two
April 2009
HOW TO AVOID DIMINISHING RETURNS – Part
two
By Jon Evans, Senior Private Banker,
Fairbairn Private Bank
We recommend that you read part one of this feature before
continuing.
As the financial turmoil and economic slowdown look set to
continue through 2009, it is becoming more and more difficult to
find effective means of maintaining returns ahead of inflation. In
an environment of falling house prices and record stock market
falls, preserving capital is becoming a challenge. Investors have
therefore become increasingly risk averse and the UK and US have
witnessed a significant move into cash deposits.
With central banks having pursued an aggressive rate cutting
policy in their effort to aid economic recovery, cash as a capital
preservation shelter is no longer offering the return it once did.
At the current time, with sterling base rate at 0.5% (the lowest
level in the Bank of England’s 315-year history), the euro base
rate at 1.5% and the US fed rate effectively 0.0%, returns are
below inflation.
It seems likely that a low interest rate environment will
prevail for some time to come and you may be concerned by this
prospect of diminishing returns on your savings. In this situation,
it could be helpful to look at some alternatives that could
potentially enhance your returns. Before looking at the options,
however, it may be worth remembering that along with interest
rates, inflation rates are also tumbling and deflationary forces
are looming large.
Whilst accepting negligible interest rates frequently hurt
savers, if inflation turns negative, in real terms, the outcome can
still be positive. In an environment where goods and services
become cheaper, savings become more valuable in terms of spending
power. New thought processes may well become necessary in the short
term, but one truism will always remain: chasing above market
returns will always be a high-risk strategy. Turning to the
two options suggested below: the first, a structured product, is
considered low risk in terms of loss of capital, but the second
option, corporate bonds, introduces higher yield with a potential
risk to capital.
Structured products are a form of deposit, or investment,
designed to provide an enhanced return over cash. They can also be
designed to provide full, or partial, capital protection.
When investing in structured products, assets are transferred to a
third party, often an investment bank, which introduces the
possibility of counterparty risk. Therefore should you choose this
option you must be comfortable that the issuer has a stable credit
rating and will be able to repay your capital at maturity.
Structured products can take many forms and we list just one
popular example available at the time of writing:
Option 3: Capital-protected
structured product
For those investors seeking capital
protection, but prepared to invest for a number of years, the
example below details a two-year structured product linked to the
FTSE 100:
At maturity, in two years time, should the
FTSE 100 be at a lower level than now, investors will receive their
capital back with no other returns. However, if the FTSE 100 has
gone up, but is below 131% of its current level, investors will
receive a return equivalent to the FTSE 100. For example, if the
FTSE 100 is 25% above its current level you will receive a return
of 125% at maturity. However, if the FTSE 100 performs very
strongly and rises above 131% of its current level at maturity you
will receive your capital plus a 3% return.
This product would suit those who are seeking
capital protection and believe the FTSE 100 is going to go up, but
not above 31% of its current level over two years.
All the terms mentioned above are indicative
and were correct at the 23 March 2009. They may not be repeatable
but act as an example for illustrative purpose.
Option 4: Corporate
bonds
While not a direct replacement for cash, in the current economic
environment corporate bonds are looking a favourable
alternative. A bond is basically a form of IOU and is a means
by which companies can borrow money from investors. Corporate bonds
can provide a relatively stable investment that can offer income
that beats inflation and cash, as well as the potential for capital
growth.
It is important to bear in mind there are risks involved in
investing in corporate bonds; the key points to consider are: what
rate of interest will I be paid and will I get my money back? The
greater the risk of not getting your money back, the higher the
interest rate you will be paid.
You should not consider corporate bonds unless you are prepared
for some volatility. However, following the crisis of confidence in
credit markets, investment grade bonds are currently pricing in a
risk of defaults in excess of 35% whereas the highest level of
investment grade default ever recorded previously was 16%.
Therefore, unless you foresee corporate failure at over twice the
worst level ever experienced before, investment grade bonds are
showing good value.
Given the prospect of continued volatility
and low interest rates in the foreseeable future, you may be well
advised to consider an alternative to simply leaving all your cash
on deposit. To talk through your individual circumstances and find
out more about these and other options available, please contact
your private banker or our client services team on +44 (0) 1624
645000.