As choice increases, investors should remember that low risk does not mean no risk and consider moving money back into financial markets
Any debate on low-risk investments has to start with cash, although money on deposit is not always risk-free. The income earned will fall if interest rates decline and investors locking in to fixed deposits may lose out if interest rates rise. The capital value of the cash, however, is relatively safe and this is the key point. As the choice of investment broadens out, through gilts, corporate bonds and guaranteed products, investors should remember that low risk does not mean no risk.
A reach for yield or capital gain will introduce an element of market risk and it is up to the investor to decide how far this should extend.
For most people, cash represents a store of value, the ready means to purchase other assets and, in difficult times, a precautionary balance against future financial demands. If they can afford it, ready access to the cash equivalent of six months' household expenditure is a comforting thought. As a store of value, it has certainly outperformed most other assets on the last eighteen months.
In an entirely rational world, this should be the time when investors are thinking about moving the money back into financial markets. The return on cash has fallen significantly and looks as if it may fall further. The debate in the press, however, has focused on fears of further market declines and it is likely that cash balances will remain relatively high in the medium term.
The disadvantage of cash, particularly if there is too much of it about, is that the expected return is always relatively low. The return is purely income, with no hope of capital gain.
Deposit rates are currently dropping into low single figures and, after tax, will barely keep pace with inflation. As a store of value, cash on deposit is a good short-term bet, but longer term there is a risk (indeed a near certainty) that the purchasing value of the investment will decline.
When you dig an old building society pass book out of the back of the wardrobe and take it in to reclaim ten years' interest on your final balance, even the power of compound interest invariably doesn't keep up with the cost of living. For most investors, the next asset to consider will be National Savings or government gilts. Again, the expected return is mostly income, although there can be some potential for capital gain. The risk is low because you do not expect HM Government to default on your loan. The money invested is expected to be returned with interest.
The most sophisticated personal investors, investment bankers and brokers, invariably hold their full quota of National Savings. There can be tax advantages and we can all dream about the chance of a substantial win with Premium Bonds. There is a modest average projected yield and, of course, the winnings are tax-free.
Gilts on the other hand are less tax-efficient, although the yield is more certain. Index-linked gilts can be attractive, particularly if you believe inflation is about to pick up, and in the past, they have offered better net returns to taxpayers, since part of the return is capital gain. Basically, the Government offers a guarantee that over the lifetime of the gilt (issues mature from 2003 to 2030), both the coupon and the capital invested will be protected from inflation.
Any investor who buys into the secondary market, and sells before the bond matures, will expect to share in these benefits but does not have any absolute guarantees. As for most guaranteed products, the promise only holds good if you hold the investment for the full term.
Supply and demand will cause index-linked gilt prices to rise and fall over time, and the best opportunities for capital growth come when investors have a sudden change of view on inflation.
When sterling crashed out of the ERM in 1992, for example, the decline in interest rates and the currency's value fuelled expectations of much bigger increases in retail prices, and the value of index-linked bonds increased sharply. Most of the time, however, inflationary expectations are relatively stable and the returns on index-linked bonds are relatively modest. You still have to pay for that guarantee.
Conventional gilts have no guarantee they will beat inflation and this is their greatest risk. Again, the Government pays a regular dividend and your money back on maturity. Investors buy gilts as a secure source of income but can suffer capital losses if the bonds are sold before they mature.
Many older bonds, issued in the 1980s and 1990s, have coupons of 8% or 9%. The return on the investment, however, will be determined by the price you have to pay for each bond. For each £100 in maturity value to be received in 2011 or 2028, you will have to pay £130 or more today. The yield over the life of the bond will even out at around 5%. Capital has not been lost; it has simply been converted into income, paid out as a running yield of around 6%.
If inflation remains low, or falls further as it has in Japan, then the value of the gilt income will increase. Japanese government bond yields, which were in high single figures in the last two decades, have fallen below 2%. If this were to happen in the UK then longer dated gilts, maturing in twenty or thirty years time, would more than double in value.
Conversely, if inflation was allowed to take off, then investors in government gilts could face significant capital declines. Gilts are subject to market risk, although the nominal income earned is secure.
A further step up the risk ladder takes the investor into corporate bonds. Like gilts, these pay a regular coupon and promise your money back at some future date. Unlike gilts, HM Government does not guarantee them. Any sales pitch that implies they are as safe as gilts is playing down the credit risk.
Some of these bonds, from recognisable issuing names, currently yield 6.5% or more. While this is attractive, investors will be exposed to the fortunes of the issuing company and its continued ability to service its debts.
The best way to limit this risk, which does not apply in the case of gilts, is to invest through some kind of collective investment, usually an Oeic.
A well-diversified, corporate bond fund offers an increased return, which is relatively safe, so long as the investor is not a forced seller into market declines. Corporate bonds are subject to the same market risks as gilts and should therefore be considered as a medium rather than a short-term investment.
Other investments, such as buy-to-let property, and income shares in split capital investment trusts, are sometimes considered as low risk. This is because the return comes from income rather than capital gain.
However, investors should remember that higher expected returns invariably come at the risk of capital loss. At the other end of the scale, equity-linked investments with capital guarantees generally give up most of the income on the investment for the hope of some capital gain. The bottom line is that low risk investments usually mean relatively low returns.
• With cash, there is a risk that the purchasing value of the investment will decline.
• Conventional gilts have no guarantee they will beat inflation.
• Higher expected returns invariably come at risk of capital loss.
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