By Uma Shashikant
Last week an 80-year old woman wrote to me about her investments. She had been receiving a pension, but hardly used it as she was staying with her son, and had accumulated 10 lakh. The relationship manager of her bank has been trying to persuade her to invest the amount in a fixed deposit of a company that was offering 11.5% per annum. She had read about the impact of inflation on investments and asked me if she should choose the product since the rate seemed attractive. The company in question is a multi-business venture going through a bad patch in several of its core businesses. Her mail was a sharp reminder of the prevailing mis-selling in the markets and the vulnerability of investors, who do not see risk as clearly as returns.
There is no investment product without risk. To invest is to allow someone else to use your money; the manner in which the money will be used and the return it will generate is always subject to the unknown. It is the degree and nature of risk that varies. Think of risk as using a road. If someone told you that you could step on to a busy road with eyes closed, you would consider it insane. To invest without considering risk is similar. It is not as if we avoid the roads from fear of accidents. We are aware of the risks and act accordingly. Unfortunately, accidents continue to happen, but we do not wish away the risk, or avoid the roads altogether for the fear of being hit. To invest is to consider the risks and act accordingly.
What are the risks that my reader did not consider? She saw the product as protecting her from inflation since the rate offered was high. An investment that grows in value, such as equity or property, inherently offers protection against inflation since the price moves up over time. An incomegenerating investment, such as a deposit, is unlikely to offer this protection across economic cycles. Interest rate is a compensation for inflation and the rates on such products tend to align with the expectation about inflation. This means that interest rates will be cyclical, moving up and down in line with the likely inflation. Therefore, high interest rates are offered when inflation is expected to be high, but during such times the products are offered for shorter maturities. No borrower, unless desperate, would lock himself into a high rate for a long period, knowing fully well that the interest rates are cyclical and would fall in the future. My 80-year-old investor is not looking at the next 20 years, but when her deposit matures in three years, she is likely to get an interest rate depending on the situation at the time. A fixed income product, such as a deposit, will, at best, help stay in line with inflation. It won’t help her beat it. High rates during high inflation is a tactical opportunity, at best.
It is not uncommon to find products with high interest rates during times of high inflation. However, care should be taken to ask why the rate being offered is high. Borrowers may be stressed; they could be in dire need of money and willing to pay a higher rate. A company deposit is an unsecured borrowing. This means the investor has no recourse to assets of the borrower if there is a default. That is the risk the investor is taking. Many would argue, rightly, that all companies do not default and that there is a credit rating for the deposit. Default risk is not just about the company failing to repay the deposit. If the situation gets worse for the company, its credit rating can drop. When a company is rated AA at the time of an issue, and is dropped at A- before the deposit matures, the risk for the investor has increased. However, the interest rate is the old one and it does not capture the new risk.
If the investor finds that the risks have gone up and wants to sell her investment, she cannot do so. The company deposit is not liquid and she must wait for its maturity. She will not be able to access the deposit if she needs money before its maturity. Her need is to be able to claim her investments if she were to fall ill and needed money for her medical expenses.
She may be able to take a loan against the deposit, but it would not serve her purpose since she has no income to repay the loan, and having spent the money on her medical treatment, she may have to end up forfeiting the deposit she offered as collateral.
The company deposit that my reader is considering has a high reinvestment risk—it is a shortterm product and she cannot assume that she will get the same rate when it matures. It has a high default risk—the credit rating of the deposit may fall even as she is holding it, and in the worst case, it may default. It has a high liquidity risk—her money is locked in with no liquidity. The 11.5% return comes with these risks, and the question she should ask is whether the product is suitable for her needs.
If her primary need is to access the money when needed, she should choose a safer and more liquid investment. Depositing the money with her bank and breaking her deposit when she needs the money might serve her needs well. She has hardly used her pension and the accumulated 10 lakh indicates that she has few needs. Chasing a higher return is not even a critical need in her case, and it is not worth taking the risk of an unsecured deposit with the company whose financial position is weak.
If she is not in a hurry to reach her destination, she is better off walking on the pavement carefully, instead of jumping on to the footboard of a crowded bus.
Source: timesofindia.com 22/10/12
Last week an 80-year old woman wrote to me about her investments. She had been receiving a pension, but hardly used it as she was staying with her son, and had accumulated 10 lakh. The relationship manager of her bank has been trying to persuade her to invest the amount in a fixed deposit of a company that was offering 11.5% per annum. She had read about the impact of inflation on investments and asked me if she should choose the product since the rate seemed attractive. The company in question is a multi-business venture going through a bad patch in several of its core businesses. Her mail was a sharp reminder of the prevailing mis-selling in the markets and the vulnerability of investors, who do not see risk as clearly as returns.
There is no investment product without risk. To invest is to allow someone else to use your money; the manner in which the money will be used and the return it will generate is always subject to the unknown. It is the degree and nature of risk that varies. Think of risk as using a road. If someone told you that you could step on to a busy road with eyes closed, you would consider it insane. To invest without considering risk is similar. It is not as if we avoid the roads from fear of accidents. We are aware of the risks and act accordingly. Unfortunately, accidents continue to happen, but we do not wish away the risk, or avoid the roads altogether for the fear of being hit. To invest is to consider the risks and act accordingly.
What are the risks that my reader did not consider? She saw the product as protecting her from inflation since the rate offered was high. An investment that grows in value, such as equity or property, inherently offers protection against inflation since the price moves up over time. An incomegenerating investment, such as a deposit, is unlikely to offer this protection across economic cycles. Interest rate is a compensation for inflation and the rates on such products tend to align with the expectation about inflation. This means that interest rates will be cyclical, moving up and down in line with the likely inflation. Therefore, high interest rates are offered when inflation is expected to be high, but during such times the products are offered for shorter maturities. No borrower, unless desperate, would lock himself into a high rate for a long period, knowing fully well that the interest rates are cyclical and would fall in the future. My 80-year-old investor is not looking at the next 20 years, but when her deposit matures in three years, she is likely to get an interest rate depending on the situation at the time. A fixed income product, such as a deposit, will, at best, help stay in line with inflation. It won’t help her beat it. High rates during high inflation is a tactical opportunity, at best.
It is not uncommon to find products with high interest rates during times of high inflation. However, care should be taken to ask why the rate being offered is high. Borrowers may be stressed; they could be in dire need of money and willing to pay a higher rate. A company deposit is an unsecured borrowing. This means the investor has no recourse to assets of the borrower if there is a default. That is the risk the investor is taking. Many would argue, rightly, that all companies do not default and that there is a credit rating for the deposit. Default risk is not just about the company failing to repay the deposit. If the situation gets worse for the company, its credit rating can drop. When a company is rated AA at the time of an issue, and is dropped at A- before the deposit matures, the risk for the investor has increased. However, the interest rate is the old one and it does not capture the new risk.
If the investor finds that the risks have gone up and wants to sell her investment, she cannot do so. The company deposit is not liquid and she must wait for its maturity. She will not be able to access the deposit if she needs money before its maturity. Her need is to be able to claim her investments if she were to fall ill and needed money for her medical expenses.
She may be able to take a loan against the deposit, but it would not serve her purpose since she has no income to repay the loan, and having spent the money on her medical treatment, she may have to end up forfeiting the deposit she offered as collateral.
The company deposit that my reader is considering has a high reinvestment risk—it is a shortterm product and she cannot assume that she will get the same rate when it matures. It has a high default risk—the credit rating of the deposit may fall even as she is holding it, and in the worst case, it may default. It has a high liquidity risk—her money is locked in with no liquidity. The 11.5% return comes with these risks, and the question she should ask is whether the product is suitable for her needs.
If her primary need is to access the money when needed, she should choose a safer and more liquid investment. Depositing the money with her bank and breaking her deposit when she needs the money might serve her needs well. She has hardly used her pension and the accumulated 10 lakh indicates that she has few needs. Chasing a higher return is not even a critical need in her case, and it is not worth taking the risk of an unsecured deposit with the company whose financial position is weak.
If she is not in a hurry to reach her destination, she is better off walking on the pavement carefully, instead of jumping on to the footboard of a crowded bus.
Source: timesofindia.com 22/10/12
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