How to avoid diminishing returns in a low interest rate environment
by David Stearn, Head of Business Development
 |
As the financial turmoil and economic slowdown look set to
continue into 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
witnessed a significant move into cash deposits.
|
With central banks now pursuing an aggressive rate cutting
policy in their effort to aid economic recovery, cash as a capital
preservation shelter, whilst still popular, is not offering the
return it once did. At the current time, with sterling base rate at
1.0% (the lowest level in the Bank of England's 315-year history),
the euro base rate at 2.0% 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 clients may be concerned by the
prospect of diminishing returns on their savings, therefore we
wanted to provide some options and food for thought for your
clients. Before looking at the options, savers firstly need to
remember 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
returns above the market norm will always be a high-risk strategy.
Turning to our suggested options, the first three (options 1, 2 and
3.1) are considered low risk in terms of loss of capital, but the
last two (options 3.2 and 4) introduce higher yield with a
potential risk to capital.
Option 1: Fixed term deposits
If instant access to cash is not
needed, money could be locked away for a fixed period; in this
instance a fixed term savings account would be the simplest option.
The rates currently offered increase in proportion to the length of
time that the client is prepared to fix the deposit - the
longer they are prepared to lock up their money the higher the
interest rate they will be offered.
Should this form of deposit be chosen,
the interest earned could be increased. Full details of our
current fixed term deposit rates can be viewed online.
As many economists are predicting further
base rate cuts this year, falling inflation and, possibly,
deflation, these longer term rates could very soon look
compelling.
Option 2: Cash funds
Cash funds are pooled investment vehicles that
offer a flexible and stable alternative to bank or building society
accounts. By investing into a cash fund diversification benefits
are achieved because the fund manager invests into a range of cash,
or near cash, instruments, designed to increase returns above
vanilla bank deposits. Cash funds offer competitive rates of
interest coupled with the flexibility to access savings at any
time.
As outlined above, because cash funds can
hold assets other than deposits, for example, securities such as
commercial paper that carry a higher risk than cash, careful fund
selection is imperative. We can offer guidance in this area
and currently prefer those funds that offer a well-balanced range
of assets without commercial paper.
We can also source accumulation cash funds
where investments can be left to build up without interest
being paid. This could have certain tax advantages depending
on the client's tax status. With this type of fund, tax only
becomes liable on the sale of units.
Option 3: Structured
products
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 the client choose this option they must be
comfortable that the issuer has a stable credit rating and will be
able to repay their capital at maturity.
Structured products take many forms and we
list just a couple of examples available through us at the time of
writing:
Option 3.1: Capital-protected
structured product
For those investors seeking capital
protection, but prepared to invest for two years, we can arrange a
structured deposit that is 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 is at
a higher level than it currently is but still below 134% 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 investors will receive a return of 125% at maturity. However,
if the FTSE 100 performs very strongly and is above 134% of its
current level at maturity investors will receive their capital
plus a 2% return.
This product would suit those who are
seeking capital protection and believe the FTSE 100 is going to go
up, but will not exceed 34% from current levels over two years.
All terms mentioned above are indicative and
correct at 18/01/09. These terms may not be repeatable but act
as examples for illustrative purpose.
Option 3.2: Structured product
without full capital-protection
For those people who have a need for two
different currencies and have no particular preference for which
one their deposit is held, we can arrange a structured deposit
known as a dual currency deposit. This kind of product is
similar to a conventional fixed deposit but can offer an enhanced
yield of over twice that of cash.
The dual currency deposit is usually short
term (one week to 12 months) and is linked to a specific currency
pair, one of which is the currency deposited. The terms of the
deposit are agreed before it starts and the investor must decide:
the amount and currency of the deposit, the fixed period for the
structure, and the second currency. Together with the bank, the
investor then agrees a conversion rate, or strike rate, at which
the deposit will be switched into the second currency. This rate
only becomes effective at the maturity date of the deposit.
At maturity, the investor will receive the
deposit and interest in the original currency, if the exchange rate
is higher than the level of the pre-agreed strike rate. If it is
lower than the pre-agreed strike rate the bank will repay the
deposit and interest in the second currency, with the conversion
being made at the pre-agreed strike rate.
In both cases, and in addition to the
potential benefits in switching currencies, an enhanced yield is
also applied to the deposit. For example, a one-month sterling
deposit with an alternative currency of euro, and a strike level of
0.8630 would pay 8%. This example is based on a prevailing rate of
0.9040 as at 4 February 2009. If on 4 March 2009 the exchange
rate between the two is above 0.8630, the deposit and interest of
8% are paid in sterling whereas, if it is below 0.8630, the deposit
and interest of 8% are paid in euro having been converted at
0.8630.
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 for
clients 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 their
money back, the higher the interest rate they will be paid.
Clients should not consider corporate
bonds unless they 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. Some
commentators are heralding the current time as a "once in a
lifetime" buying opportunity.
Given the prospect of continued volatility
and low interest rates in the foreseeable future, clients may be
well advised to consider an alternative to simply leaving all their
cash on deposit.
To find out more about these and other
options available, please contact us on +44 (0) 1624
645000.