Why Tracker Bonds And Cash Are Not Good For Investors

As someone who is advising investment clients for almost 25 years it never ceases to amaze me when history tends to repeat itself. Not only do we see investment bubbles form and burst with increasing regularity but we also see the emotional reaction from clients ebb and flow as well.

When markets are in the ascendency everyone, it seems, chases the latest investment trend in the same manner as fashion trends exist. In the last decade we have seen bandwagons of technology stock, property and more recently gold. When corrections occur, as they will from time to time, then an overreaction of selling the same assets materialises.

At such times, many investors who are uncomfortable with stockmarket investment but who realise that it is necessary for long term growth prefer to use Tracker Bonds which are linked to stock market indices but which guarantee a return of capital.

Such products usually lock in client monies for a fixed period varying from 3 years to 6 years. The reason for the lock in is due to the fact that between 77% and 92% of the investor capital (depending on the term involved and the prevailing interest rates) is placed on deposit for the complete term of the investment. The balance is then used to pay introducer commission, the cost of buying stock market options as well as the profit margin for the product promoter, usually a financial institution. If the institution is only dealing with, say, an 8% balance (i.e. 100% less the aforementioned 92% on deposit), then it is more likely to embark on extensive marketing in order to draw in a greater volume of funds so as to make the product a profitable business proposition for themselves. There is nothing wrong with making profit providing that the eventual investor is fully aware of what they are doing with their money.

What many investors may not appreciate is while tracker bonds fulfil a reactionary investment need for safety they invariably compromise the client more by ensuring that their money becomes inaccessible for the period of the investment, which can be up to over six years in length. If no growth is achieved on the stock market portion of the tracker bond, then the client receives only that amount which was guaranteed, usually the original investment. Most such investors overlook the fact that their monies actually incurs a loss in value due to inflation in the intervening period. Considering that the long term Eurozone inflation averages out at 2% (if you ignore our recent deflationary experience) then the growth needed just to maintain purchasing parity is actually 2.74% p.a. if allowance is made for DIRT of 27%, which is the tax rate that now applies to all tracker bonds. Over time, these amount to a significant loss in real value.

If these were the only considerations then a relatively submissive investor might dismiss these drawbacks if their main concern is to at least know that a substantial portion of their money is safe. Safety is, like beauty, in the eye of the beholder. All tracker bonds carry what is referred to as counterparty risk, whereby the guaranteed return of capital is available only if the guaranteeing institution is still capable of fulfilling the return of capital. If a financial institution’s trading status is compromised, so too is its ability to give guarantees or, more importantly, fulfil them.

In my experience many investors rarely read the small print of investment brochures or contracts, trusting instead the adviser’s wisdom. A noticeable clause in such documents, for those eagle eyed enough to read them is now, since 2008, the specific reference to this counter party risk. Whether the return of capital is guaranteed by the promoting institution or the bank with whom the monies are actually deposited, there is a real risk that a default by the institution could occur.

This counter party risk is no different than that which exists if a person places money on deposit directly with a bank. While the EU wide Deposit Guarantee Scheme is in place to protect up to €100,000 per person, any excess can be more at risk with one bank than another, depending on the relative banks’ own financial ratings. Generally, the higher the investment rating of the institution, the lower the deposit rate offered. Inversely, those financial institutions that need funds to improve their own solvency and liquidity reserves tend to be higher risks and therefore need to offer a higher deposit rate to attract funds.

In recent times, many Irish people have transferred monies away from the Euro and into other currencies such as Swiss Franc, Norwegian Kroner or Sterling on the premise that these currencies are safer relative to the Euro. In so doing, investors (or more aptly, deposit holders) have already taken substantial risk which can result in substantial losses being incurred if the new currency holding loses value relative to the Euro. In many cases currency losses can arise quite swiftly without any immediate hope of recovery. The recent 8% devaluation of the Swiss Franc by its own Central Bank is a case in point.

The bottom line is that there are no sure bets and everything, even apparent safety, comes at a price.