The Fincorp debacle is a sobering reminder that high returns do not come without high risk. The appetite for high-yield investments has grown significantly in recent years as the low interest rate environment made investors look further afield for a better income return. Some of these options bring with them more risk than many investors realise. They see words like mortgage and property in the product descriptions and equate this with a level of security that is not the case. Investors take comfort from bricks and mortar when, in fact, the properties might just be holes in the ground that need to be developed over a number of years, and at significant expense, before there is the potential for a decent return on the investment. This assumes there is a return at all given the high risk nature of many of these projects. After all, if they could get funding from the mainstream banks surely they would rather than pay more to borrow the funds. The trouble is the banks will not touch many of these projects, and where they do they make sure they are the first cab off the rank to get their money back.
My colleague, Paul Clitheroe, did some research into offers like Fincorp’s and what he found was frightening. His researcher spoke to one salesperson who promised an investment in one of these debenture products was “safer than a term deposit”. This was not the case, but inexperienced investors, who are less able to ask the right questions, can be seduced by a high rate. In the case above, Clitheroe went back to the provider, who was forced to admit the investment was nowhere near as safe as they were making out. Investors do not appreciate that for every additional 1 per cent of return in fixed interest you take on significant risk. As a consequence, rates well above the cash rate are a big risk. In essence, investors are promised an equity-like return but with a level of risk way beyond that of equities. The higher interest rate options vary significantly from high-risk debentures and unsecured notes, like the ones offered by Fincorp, to fixed income instruments with different levels of security.
As advisers would know, debentures are loans to a company. If the company goes bust, debenture owners can salvage some of the value from a charge over the company’s assets. For Fincorp, the initial indication is the debenture holders may receive 30c in the dollar. Even higher yielding unsecured notes are also loans to the company, but with no priority charge over the assets. The Fincorp note holders may get nothing. These types of high-risk debentures and unsecured notes illustrate the risk of mezzanine financing that sits behind many of these products. Mezzanine financing has long been used by institutional investors who diversify project and developer risk. Institutions also expect the pay-off to be over the medium term. Products targeted at retail clients offer significantly lower yields (8-12 per cent for retail investors versus 20-30 per cent for institutional investors) and are less diversified. Further along the income spectrum are pools of income-producing assets rather than loans to a single entity.
An investment in mortgage-backed securities provides access to the cash flow of mortgages. Investors usually access a collection of mortgage-backed securities through pooled structures. There is a huge range in the riskiness of various pools. Some structures only invest in low-risk, well-secured assets. Expect these funds to offer lower yields, and they often carry a strong credit rating. The good ones are also well diversified – something investors are not achieving with a single exposure to a high-yield debenture. Some fund managers, in an attempt to generate greater yield, have increased exposure to lower-rated mortgage-backed securities, for example, including a higher level of development loans. In an environment of rising property prices and stable interest rates, these products have had a low level of default. If circumstances change, investors in lower-rated mortgage-backed securities may be exposing themselves to significant risk.
Then there are collateralised debt obligations (CDO). They are portfolios of corporate securities, diversified across a range of credit ratings. Recently CDO issuers have been forced to include more lowly-rated credit securities to maintain the level of yield as credit premiums have declined. While yields have fallen, so have default rates, benefiting investors. The potential danger for investors is a return to historical average default rates. In this scenario, investors in CDOs may be exposed to a potentially high level of capital loss, due to their high exposure to low-rated corporates. Income funds may invest directly into a range of income-generating assets. In principle this is a much better way of getting diversification as the risk is determined by the fund’s investment policy. Some only invest in the low-risk/very secure end of the market; others may have much higher risk. If a fund is offering a higher yield than average, chances are it is carrying higher risks. Investors need to recognise that yield communicates information about the potential riskiness of investments. In a low interest rate environment, where investors are not being compensated for term premium, high rates indicate a significant level of credit risk. It is our job as advisers to educate clients on these risks and bring to life the disastrous impact of permanent capital loss on their future lifestyle.
