Blair Carmichael - 01/05/2019
Whilst accepting investment risk is an important part of medium to long term financial planning, it isn’t for everyone, or for all of a portfolio. There will always be a need for deposit-based alternatives which, ideally pay interest and do not put capital at risk. Most portfolios will have an element of instantly accessible deposit-based funds but may also have some longer-term deposit capital.
The Financial Services Compensation Scheme (FSCS) provides a layer of protection for depositors, protecting up to £85,000 per bank, per individual. This protection extends to include Structured Deposits that may return more interest than a traditional bank deposit.
Structured Deposits are similar to a fixed rate bond, however the interest that would otherwise be payable at maturity is not fixed but is instead, linked to a defined underlying measure, often the FTSE 100 Index. The result is that the depositor could earn no interest at all, or a lot more than they would have received from a fixed term deposit and anything in between.
For example, the Investec FTSE 100 6 Year Deposit Plan 11 offers a potential interest payment of 42% at the end of six years, if the average closing level of the FTSE 100 Index in the last six months is higher than where it was at the start of the term.
At an equivalent compound rate of over 6% per annum (if the FTSE rises), the potential interest rate is significantly higher than any fixed term deposit on offer but of course, whilst capital is protected, there is a chance that the Investec deposit could return no interest at all (if the FTSE falls). The best five-year, fixed rate bonds currently available offer around 2.6% so it is easy to establish what is being risked in order to potentially achieve the higher return.
Deposit based kick-out structured products may be used to increase the likelihood of a positive outcome and reduce the risk of not achieving any interest.
The Investec FTSE 100 Kick-out Deposit Plan 84 for example, offers a potential payment of 6% simple interest per annum, with the opportunity to ‘kick-out’ from the third anniversary, if the closing level of the FTSE 100 is higher than where it was at the start of the term. If it matures on the third anniversary the interest payment will be 18% which equates to a compound annual return of 5.62%.
Whilst the kick-out feature may result in the deposit maturing after three years, savers should still be prepared to commit to the full term and accept that they have no control over whether the plan will last that long, or mature on one of the earlier observation dates.
With fixed rate savings accounts offering an effective guaranteed interest rate ranging from around 2% for a one-year commitment, to 2.6% for a five-year bond; investing in the Investec structured deposit kick out plan involves sacrificing the known interest, which will be delivered with the original capital at a known date, in return for a potentially much larger interest payment. Subject to the positive performance of the FTSE 100 Index, this interest will be paid with the original capital no sooner than after three years, with corresponding early maturity opportunities occurring in the fourth and fifth years. Should the index fail to meet the reference level in year six, investors will receive their capital back but with no interest payment.
Savers need to weigh up the potential opportunity cost of using a structured deposit over a fixed rate savings product. Whilst not suitable for all deposit elements of a cash portfolio, elements of long-term cash held in structured deposits, alongside more traditional accounts may prove to be beneficial.
Accepting that past performance is not a guide to the future, the average annualised return on all of the 772 structured deposits that matured between January 2009 and December 2018 (a period when the Bank of England Base Rate was consistently below 1%) was 3.69% over an average term of four and a half years. Of all of these, 610 had their interest payment determined by reference to the FTSE 100. Collectively, these resulted in an average annualised return of 4.16% and ran for an average duration of 4.3 years. Whilst none of these made a loss due to the nature of structured deposits, 76 matured with no interest payment.
Details of all new structured deposits offered through the intermediated space can be found on www.CompareStructuredProducts.com as soon as they are launched.