Paying for certainty … but after the flood?

During periods of higher interest rates, combined with equity and currency market stress, investors are attracted to the certainty of outcome and capital protection offered by fixed deposits and structured products. However, there are costs.

30 Aug 2022

6 minutes

Paul Hutchinson

With interest rates on the rise, it’s not surprising that advisors are seeing a plethora of retail guaranteed investment products being promoted by various financial service product providers. This is because, at its simplest level, higher interest rates reduce the cost of guaranteeing a minimum maturity value.

Essentially, to ensure capital protection, the product structurer allocates a portion of the amount invested to a zero coupon bond; being a debt instrument that does not pay regular interest, but rather pays out the face value of the bond at maturity. The higher the interest rate, the lower the amount required to be invested upfront to return the capital invested.

By way of example, to return R1 million after 5 years you need to invest approximately R680 000 if interest rates are 8%, but only R620 000 if interest rates are just 2% higher at 10%. This means the product structurer now has an additional R60 000 to allocate for growth; normally via buying a derivative instrument like a call option on a specified financial instrument (stock, bond, commodity, index).

At the same time, higher interest rates are also making fixed deposits optically more attractive. And, given that 2022 has seen significant market corrections across almost all asset classes, it’s not surprising that many investors are tempted by the implied capital protection and certainty of outcome offered by structured products and fixed deposits. But at what cost?

Negative real returns

The following chart illustrates that, even though the repo rate has been raised by a cumulative 2% from its low of 3.5% in July 2020, investors in the South African money market can expect to earn negative real returns (currently meaningfully negative after inflation and income tax) for the foreseeable future. The money market will likely again be a poor investment in preserving the purchasing power of your money over the medium to long term.

Figure 1: South African inflation, interest rates and money market returns

Figure 1: South African inflation, interest rates and money market returns

Source: Morningstar and Ninety One, June 2022.

Lack of liquidity and flexibility

Generally, both structured products and fixed deposits are designed to be held to maturity. As a result, anyone needing to exit early, will likely have to redeem at a discount / penalty based on prevailing market conditions and liquidity, which may result in a loss. Often there is no transparency in the calculation of this penalty, and it can be substantial. Furthermore, the time taken to process a redemption (if it is possible) is also likely to be materially longer than the two to three business days for unit trusts, with the result that you may miss an attractive entry point for an alternative investment.

The structured product’s growth asset exposure is also fixed at inception, and investors are dependent on how it performs over the term of the product. Given the uncertain political, economic and investment environment, the decision to lock up money for a fixed term may prove riskier than investors realise; for example, the rand may become more attractively priced and / or relative equity valuations more compelling, making for more attractive entry points, which may be missed if capital is locked up.

By comparison, a unit trust, private share or segregated portfolio manager has the flexibility to change the underlying assets in the portfolio depending on changing relative valuations, macro-economic factors, etc.

Complexity and cost

In most cases the design of a retail structured product can be quite complex, making it essential for investors and their financial advisors to fully understand how the product will perform under various market scenarios. Also, as most structured products offer explicit capital protection at maturity, it is important for investors to understand the terms of the guarantee. This is because, in some instances, the guarantee may only apply if, for example, the reference asset does not fall by more than a specific amount.

Investors must also consider the costs inherent in the product, both the direct (e.g., management and distribution fees) and indirect costs (e.g., where the return is based on the performance of a reference index, but in most instances the investor forfeits the dividends – the historic dividend yield of the FTSE/JSE All Share Index is close to 3% per annum, and current yield at almost 4%).

Capital protection

While a capital guarantee does provide peace of mind, it may prove unnecessary for longer term investors. The following chart shows the rolling five-year performance of the FTSE/JSE All Share Index. You can see for the period shown, which includes the Global Financial Crisis and the Covid-19 correction, there has only been one negative rolling five-year return: the minimum return being -0.1% p.a., the maximum being 36.3% p.a. and the average rolling five-year return being 13.8% p.a.

Figure 2: Rolling five-year returns of the FTSE/JSE All Share Index - Figure 3: Rolling five-year returns of the MSCI ACWI (in rands)

Source: Morningstar.

The picture is only marginally different for an offshore investment converted back to rands. Figure 3 shows that the MSCI All Countries World Index (ACWI) in rands has delivered a negative rolling five-year return only 2% of the time for the period illustrated (198 rolling five-year periods), with a minimum rolling five-year return of -1.5% p.a., a maximum return of 25.8% p.a. and an average return of 11.9% p.a.

In short, for much of this period, rand based investors have been paying for a guarantee that they did not require.

Consider the Ninety One Cautious Managed Fund

As an alternative, these conservative investors could consider a multi-asset, absolute return fund such as the Ninety One Cautious Managed Fund, which targets inflation plus 4% p.a. over rolling three years and no negative returns over rolling 18 months. The Fund benefits from having the flexibility to allocate across asset classes, and while it has a bias to fixed income assets, it also invests in growth assets. Since inception, the Ninety One Cautious Managed Fund has grown wealth in real terms (3.2% per annum above inflation1) – a 16-year period that spans three significant global equity market corrections, including the Global Financial Crisis - while providing downside protection as illustrated in the following chart.

Figure 4: Ninety One Cautious Managed Fund, upside participation with limited drawdowns (rolling 18 month returns)

Figure 4: Ninety One Cautious Managed Fund, upside participation with limited drawdowns (rolling 18 month returns)

Source: Morningstar, 30 June 2022.

It’s about the trade-offs

There is no doubt that the certainty of outcome, and capital protection provided by structured products and fixed deposits can appear attractive to investors – especially during times of higher interest rates, combined with equity and currency market stress. However, there is a cost to that certainty; potential negative real returns, lack of liquidity and investment flexibility, combined with complexities around benefit conditions and cost structures. And all this for a guarantee that many long-term investors don’t really require.

We would advise investors considering products like these to seek professional financial advice to make sure that the trade-offs are suitable to their individual circumstances.

 

1Source: Morningstar, 30 June 2022.

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Paul Hutchinson
Sales Manager

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