18 Sep There's Still No Such Thing As A Free Lunch
Photo credit: Sakurako Kitsa on VisualHunt / CC BY-NC-ND
“The free lunch has still to be invented.” – Alan Greenspan
The Risk-Free Rate
For investors seeking income, life has been challenging for many years now.
Investors generally want their income to be relatively secure and obtainable without taking excessive levels of risk, therefore any investor’s starting point should be the ‘risk-free rate’, i.e. the rate of return freely available with zero risk. In reality, no investment could be described as zero risk, as calamity can befall even the most secure government or financial institution.
In the UK, we would typically define the risk-free rate as the current yield on the 10-year Treasury bond. At the time of writing, this is 0.187%. Or in other words, virtually zero.
It seems astonishing to me now that for the first half of my career as a financial planner, the risk-free rate was in the region of 10%!
So, with a starting point of 0.187%, can we – safely – do any better than a 10-year Treasury?
Well, the next best option, in terms of security of returns, would be products offered by National Savings & Investments, (NS&I) as these are issued, and backed, by the UK government.
For instant access savings, their Direct Saver account currently pays 1% per annum on deposits up to £2m. 100% of your capital has the backing of the UK government, compared to that offered under the standard Financial Services Compensation Scheme (£85,000 per person, per financial institution), however, the rate of interest on this account, unlike that from the Treasury bond (which is fixed) is variable and could therefore fall. NS&I has in fact already flagged its intention to reduce the interest rate payable, although it has been delayed following the pandemic.
NS&I does offer a couple of fixed-interest products, but these generally do not provide the same easy access as you have with a Treasury bond.
Once you move away from the risk-free rate, the only way to obtain a higher return is to take on more risk. I’ll say that again, as it’s worth repeating. Once you move away from the risk-free rate, the only way to obtain a higher return is to take on more risk.
Higher yields are available – at a price
These (potentially) higher returns can be obtained from corporate bonds (currently 2.34% for AAA-rated bonds), equities (the current yield on the broad UK market is 4.5% – a historically high level) – and then there are the more ‘esoteric’ products…
Like most people in my line of work, I get a fairly regular stream of such products hitting my inbox. One which stood out to me very recently offered the following:
- 1-year bond
- Minimum investment £250,000
- Maximum amount to be raised £50,000,000
- Quarterly payments
- Annual coupon 20% gross
- Return of initial capital investment at the end of the term (less 2% costs deducted at the outset)
No, that’s not a typo, that really is a 1-year bond paying 20% – when the risk-free rate is 0.187%.
Well, tell me more!
Ok, well, first up, your investment is not covered by the Financial Compensation Services Scheme (Quelle surprise).
The company issuing the bond is not regulated by the Financial Conduct Authority (FCA), or any other country’s regulator.
However, the bond can only be sold by regulated intermediaries (see what they did there? Way to transfer risk from your own entity to some other mug’s).
The bond is only available to certified high-net-worth investors (well, that’s a relief to know that not just anyone can benefit from this incredible investment opportunity).
The Memorandum reassures us that the issuing company “are experts in wealth creation and onward maximisation” (whatever that means). Companies House reveals that the company was incorporated in October 2018 but was dormant until March this year.
Too good to be true?
Let’s just remind ourselves, this is a product offering 20% gross income, paid quarterly, and return of 98% of your capital at the end of the term. And the risk-free rate is 0.187%.
The Memorandum goes on to state that “Low risk and high returns are key features most investors look for when building a successful portfolio.” (You don’t say).
And that “Capital preservation and security are paramount in most investors’ strategy. Therefore, the Issuer believes that the most sought-after investment model is one which provides healthy returns with minimal risk to capital and for many, this is the holy grail of investing.” (Can’t argue with that).
So, how, exactly, in a world where the risk-free rate is 0.187% do you generate a 1-year return of 20% with ‘minimal risk’? And how do you define ‘minimal risk’?
Well, the answer to the first question is arbitrage. It’s a perfectly valid investment strategy, but is it one which any reasonable person would describe as being ‘minimal risk’? It’s a trading strategy most often employed by hedge fund managers – not an asset class that many would define as ‘minimal risk’.
Like most investment strategies, it requires skill and/or luck in its execution. The issuing company provides no evidence of previously having demonstrated either, which is possibly why the terms of the contract state that “The Bondholders may, by special resolution, agree to modify, abrogate, or compromise any of the provisions of the Bond Instrument or the Conditions.” (Heads, I win. Tails, I also win).
I hate to see products like this being marketed to investors. Yes, they may be restricted to ‘sophisticated’ investors, but the risk of many potential investors looking little further than the headline rate is high, while the chance that many understand the risks involved in an arbitrage trading strategy is low but sadly there are regulated intermediaries who will recommend this product to their clients.
There really is no such thing as a free lunch. Risk and return are related. For a product offering almost 20 x the risk-free rate, the risk to capital must be substantial – and certainly not ‘minimal’.
It would be interesting to see how this one pans out. My business partner is currently contracted as an expert witness by the FCA in a case involving a product which promised much and epically failed to deliver, leaving a trail of investors nursing significant losses in their wake. I wish I understood why unregulated products can be marketed at all in the UK. And I do wonder why companies choose not to be regulated (I have my opinions, obviously 😉), passing the buck to regulated intermediaries willing to take on that risk. And most of all I wonder how on earth any decent firm could possibly recommend products like these to their clients.
Carolyn