Examine any best buy table and you will currently see a host of fixed rate savings bonds with headline rates hovering around the 7% mark. Ostensibly, this is mouth-watering stuff but once you factor in tax and inflation, you have to ask if depositors are making much, if any, positive headway. So how are IFAs responding?
One option for IFAs keen to steal a march in this area is the annual kick-out product. Currently offering double-digit headline rates due to market volatility, these investments pay a fixed return – plus the original capital back – after 12 months provided the market to which the investment is linked has not fallen at the date of the first anniversary. If it has, the plan simply continues until its second anniversary, when it will kick-out – this time delivering twice the return – if the index level then reaches or exceeds its original starting level.
This can continue all the way through to a maximum term, commonly five or six years. Now, if by the end of this maximum term the index, at any point during the term has fallen below a predetermined level, investors’ capital will not be repaid in full; it will commonly be reduced by the fall in the index’s final level compared to its original starting level.
But for investors willing to take on some level of risk, then on a net/net basis – bearing in mind these products are often subject to capital gains tax rather than income tax – they can be a very attractive option.
As compelling as some of the returns may appear, however, there is a caveat attached. These products are by no means homogeneous and the lack of uniformity means care should be taken when comparing them. The simplest products base their returns on the performance of a single index, facilitating straightforward tracking and monitoring. But others are linked to two indices and rely on the worst performing of the two to determine whether or not a pay-out condition has been fulfilled. Now, there is nothing wrong with this – these products have been carefully designed - but advisers should be aware that the higher headline rates carry additional risk.
It is also crucial to understand that the level of risk chiefly depends upon the correlation of the indices in question. For instance, the FTSE 100 and Eurostoxx 50 are 90% correlated, meaning that they move largely in tandem without absolutely mirroring one another. The FTSE 100 and Nikkei 225, however, are just 75% correlated, meaning that products linked to the two indices inherently carry greater risk. Clearly, this needs to be factored into the terms offered.
Futurevc.com estimates that a six-year product linked to FTSE 100 and Nikkei 225 has a 22.3% chance of delivering a zero or negative return; the corresponding figure for a product based on the FTSE 100 alone is 11.3%, cutting that risk in half.
Naturally, the dual product offers a potentially higher benefit – by 50% or more – but advisers need to consider exactly what they are comparing when seeking products able to offer savings rate-beating returns.
Colin Dickie is director at Barclays Wealth
The views expressed in this blog are those of the individual.IFAonline
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