Seeking shelter from the storm
Recent financial turmoil has raised serious questions about where it is safest to stash cash. Annette Sampson examines the fine print across a range of options and the kinds of protection and security offered.
Recent financial turmoil has raised serious questions about where it is safest to stash cash. Annette Sampson examines the fine print across a range of options and the kinds of protection and security offered. Looking for somewhere safe to stash some cash? Then a good pair of reading spectacles or magnifying glass should be the first thing you reach for.The search for a safe haven is not nearly as simple as it should be. All types of investments make claims to being guaranteed, secure, safe, or stable, but when you scratch the surface, those claims are often overstated.So what's behind some of the popular safe havens and how secure are they in reality?BANK DEPOSITSIf we're talking serious safe havens, this is about as secure as you can get. Thanks to the government's decision to guarantee most bank deposits, your savings account or term deposit is not only backed by the financial institution holding your money but by the government in the unlikely event your bank gets into trouble."It's a real guarantee backed by the government's AAA credit rating. You can't get better," says the chief executive at van Eyk Research, Mark Thomas.The guarantee currently applies to deposits of up to $1 million but will be reduced to $250,000 from February 1. The limit applies to all your deposits with a particular financial institution - so if you had three accounts worth $100,000 each with the same institution after February 1, $50,000 would not be covered by the guarantee.Term deposits that existed on September 10 will continue to be covered at their current level until December 31, next year, or until the deposit matures, whichever comes first.The guarantee applies to all deposits with registered deposit-taking institutions - credit unions and building societies as well as banks - but will no longer apply to foreign branches of Australian institutions from February. Dixon Advisory's managing director of the investment advisory team, Lyle Meaney, says that covers most institutions that Australians would deposit with but it still pays to check.CASH INVESTMENTSThe guarantee, however, does not cover non-deposit products such as cash management trusts and mortgage funds. Meaney says while cash management trusts might look a lot like the cash management accounts covered by the guarantee, they are not covered because you are effectively investing in money market securities.He says some institutions, such as Macquarie, have restructured their cash management trusts as accounts so that the guarantee applies.Meaney says cash funds not covered by the guarantee still have a high level of security as they typically invest in instruments such as bank bills and overnight cash. However, it pays to research what the fund is able to invest in. Some "enhanced cash" funds lost money during the GFC because they tried to boost their returns by investing some of the portfolio in less secure investments.Thomas says some industry superannuation funds also had part of their "cash" portfolio in infrastructure."You need to know exactly where the money will be invested [if you're looking for security]," he says. "It needs to be in bank bills and overnight cash."BONDSGovernment bonds also carry a government guarantee but Meaney says he would question whether they are worthwhile for retail investors with current yields of about 4 per cent, which is less than you can get in many savings accounts and term deposits.The main advantage of bonds over cash and term deposits is that you can make a capital gain by selling your bond if interest rates fall. But by the same token, the market value of your bond can fall if interest rates rise - though you are still guaranteed to get the full face value of the bond if you hold it until it matures.Meaney says investors can get more interest by investing in corporate bonds. However, these are guaranteed by the company borrowing the money, not the federal government, so the borrower's credit quality is critical.He says corporate bonds rank at the top of the ladder if a company gets into trouble. Bond holders rank above shareholders and unsecured creditors if the company is liquidated. But there might still not be sufficient funds available to ensure you're paid out in full.Thomas says in Australia, any securities rated less than BBB are not regarded as investment grade. But Meaney says an added problem for investors is that ratings agencies copped such a pasting during the GFC, they no longer provide credit ratings to the retail market. He says this has led to a flight to quality, where retail investors are generally only willing to support issues by companies they know and trust.PREFERENCE SHARES AND HYBRIDSBoth preference shares and hybrids are treated as equity in the event of a company collapse, which places you right down the queue in terms of getting your money back. Unsecured notes are also riskier than bonds as they are not backed by the company (or issuer's) assets and debentures can be backed by a general charge over the borrower's assets or secured against a real asset such as property, land or plant.The levels of security vary enormously but this doesn't stop promoters touting them as safe investments. Meaney says investors should understand that the higher return offered from these assets is due to the fact that they are riskier - even though they might pay regular income and look a lot like bonds or term deposits."A lot of the recent hybrid and preference share issues have been done by the banks," he says. "Retail investors only have an appetite for quality issues. What they're really saying is they can get 7 or 8 per cent by taking more risk but they don't want to take a lot more risk for that extra 1 or 2 per cent."ANNUITIESThomas says older-style life insurance products such as annuities are generally backed by one of the life office's statutory funds or the life office itself. The Australian Prudential Regulation Authority stipulates minimum prudential standards to back different types of assets, to ensure the company has provisioned against losses and can stand by its guarantee.He says, however, there are different levels of guarantees on offer. Some products guarantee your capital, some your income from the fund and some a combination of both. So you need to investigate what, exactly, is guaranteed.The managing director of Path Independent, Geoff Watkins, says there are two types of guaranteed annuity-style products - those backed by the life insurer itself or one of its statutory funds and those that don't offer an explicit guarantee but invest in a portfolio of high-yielding assets - products such as share funds. The risk of loss is managed by "dynamic switching" between holding those funds outright and holding cash."It's like having an option," he says.Watkins says there are often "quite a few risky assets behind what the customer sees" but so long as they are managed well, it should be OK.He says, however, it is still important to find out what sort of guarantee (if any) you are being offered and who is standing behind it.DYNAMIC HEDGINGThere are also a range of products that claim to offer varying degrees of capital protection. Watkins says AXA's North investment and retirement product is one of the better-known examples and offers a form of guarantee through a "ring-fenced" entity. He says, in effect, this means your investment is not guaranteed by AXA Life but by one of its smaller statutory funds.If the fund was suddenly required to pay everyone their capital, he says, it wouldn't have the resources to do so but it is managed so that the risks of capital loss are hedged using instruments such as futures and options.The founder of Funds Focus, Sulieman Ravell, says AXA North is one of the few companies still offering capital protection through dynamic hedging. "It's a complicated product to understand," he says."There are about 49 funds you can protect with it. What you do is pick managed funds where [AXA] can mirror what the fund manager is doing and hedge the risk using call options. If you choose a fund, for example, that correlates quite closely with the ASX200 index, [AXA] can buy call options over the ASX200 and make up any shortfall performance itself."Ravell says it is not cheap the fees are 3 per cent to 4 per cent a year. But you can turn the protection off if you feel you no longer need it and stop paying. He says the fees are also explicit, whereas they are often hidden in other protected products. The product is also flexible, offering an array of periods that you can choose to be protected a rising guarantee so that any gains you make on your investment can also be guaranteed and the retirement option guarantees a set income for life - even if you run out of money.BOND AND CALL PROTECTIONRavell says this is probably the most common form of protected product on offer in the current market and uses a risk-free investment such as government bonds to protect your capital, with the excess being invested in riskier assets.The idea is that if you invest, say, $1000 for five years, $650 will be locked away in government bonds. At the end of the five years, that $650 will be worth $1000. The other $350 can then be invested in higher-risk assets without fear of loss. Typically, Ravell says, that $350 would be "geared up" through the purchase of call options to give you $1000 worth of exposure to the riskier investment. So you should get similar performance to what you would have achieved investing in the asset directly but with your initial $1000 guaranteed to come back.However, there are a couple of downsides to this arrangement. For the guarantee to work you need to lock in for a fixed period - usually five or more years. Ravell says you also miss out on dividends, which increases the effective cost of the investment.He says it is also important to understand the terms and conditions of these products. Some put a cap on your upside gains limiting you to, say, 60 per cent of any gains made on the investment. Some have a "volatility overlay", which reduces your exposure to the riskier asset when markets are volatile (which also has the bonus of reducing the manager's hedging costs).The amount invested in bonds will vary depending on the term of the product (the shorter the term, the more money that has to go into bonds) and some products also have an enhanced or reduced "participation rate" where you get a proportion (such as 80 per cent or 120 per cent) of investment returns.Ravell says some products are now offering annual income as part of the deal but investors should be on the alert for any conditions attached to that income. Some, for example, only pay the income if the investment has exceeded a certain rate of return (say 10 per cent) in that year.But investment markets don't go up in straight lines. You might average 10 per cent a year over the five-year term but if the bulk of that growth happened in the past two years, for example, you could get only two years' income payments rather than five.These products also tend to come with lower caps. "There's no such thing as a free lunch," he says.CPPIRavell says this form of protection (known as constant proportion portfolio insurance) has fallen from favour since the GFC and is rarely used for new products. It automatically moves your investment into cash as the market falls and back into shares as the market rises to ensure a minimum fund value at the end of the term.But, as the GFC demonstrated, there is a fatal flaw. If markets fall to the extent that all of your money is moved into cash, your investment becomes "cash-locked". The manager can't guarantee your minimum final value if it moves any of your money back into riskier assets so it remains in cash for the rest of the term.Ravell says that's bad enough if you used your own money to invest. But many investors were convinced to borrow to invest in these products. They can either cash out now and pay any shortfall themselves (assuming the product allows it) or keep paying interest on the loan until the product matures and they get the money they need to repay the loan.PUT OPTIONSRavell says these are the simplest form of protection - a lot like buying an insurance policy to protect you if markets fall. The only catch is that the protection becomes more costly when markets are more volatile.Products such as protected equity loans use put options to guarantee that the underlying shares can be sold at their purchase price.If the shares tank, you can walk away from the loan without having to repay the difference between the current value of the shares and your loan amount. Instalment warrants also use put options.Questions to ask- What is being guaranteed?- Who is standing behind the guarantee? Is it the government? The product issuer? A particular fund? Or is the guarantee more a form of protection determined by how my investment is managed?- What are the terms of the guarantee? How long do I have to wait to get my money back? Can I get out early if I need to?- What does the protection cost? Am I giving up part of my return to pay for it?- What happens in the worst case scenario where the underlying investments become worthless?- What is the counter-party risk? In other words, should I trust the company behind the guarantee?- Do I understand what I'm getting into?