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Capital risk

We are looking at investment risk from two angles. Many types of investment provide us with our return in two forms, an income and a lump sum. Some of these investments are market-based: we rely on selling them to someone else to get our lump sum. With these types of investment, the risks to the income and to the lump sum are different. The income risks are connected with the business (dividends and rentals depend on the continued success of the business or the tenant), whereas the risk to the lump sum depends very often upon emotions such as fear and greed and fashion as well as the perceived security of the income. We will look more at the market risks on the next page. Meanwhile, let’s look at the risks associated with investments that are less dependent on markets.

Fixed interest investments

This group of investments includes index-linked (IL) products (where the income and capital value change with RPI and are therefore not literally ‘fixed’). However, the linking is explicit and returns are predictable enough for IL to be counted along with bonds, debentures, and preference shares in the fixed-interest asset class. Although some government bonds, and building society ‘permanent interest bearing shares’ (PIBS), are not redeemable, most do have a redemption date although this may be twenty years or more in the future.

A known income stream and a known redemption value and date take away much of the guesswork that drives prices in the markets for financial assets. There are still unknowns – inflation and future interest rates are the main ones – but government bonds are free of business risk and their prices are correspondingly stable.

Bonds, debentures and preference shares issued by companies do carry a business risk. The credit rating agencies change their assessments of the quality of corporate (company) and local authority issues and this will be reflected in the market prices. However, the essential feature of this type of investment is that the present value can be calculated with a fair amount of accuracy and not too much guess-work.

Default risk

The risk for fixed interest investments (and savings accounts) affects both income and lump sum (capital) since both reflect the probability that borrower will be unable to meet its obligations to those of us who have bought its bonds or debentures or have an account with it. Government bonds (including National Savings products) are as near risk-free as we are likely to get and there is no way we can reduce it any further. If a government defaults on one bond it is virtually certain to default on them all. There may be reasons why we would choose to hold a spread of government bonds but default risk is not normally one of them.

Buying bonds issued by overseas governments carry a currency risk (as do other overseas investments). There may be reasons why you would choose to have a proportion of your investments outside the country, but variations in exchange rates add another element of risk. Of course, we are talking about bonds issued by central governments in stable countries with stable currencies. If you want to take a punt on some banana republic somewhere then that’s a different story altogether!

There are many fixed interest investments issued by companies and other organisations (the BBC for example), and we can and should reduce default risk (or the effect of a reduced credit rating) by diversifying. As with equities and property, we can choose to diversify directly by buying a reasonable number of investments or by investing through some form of pooled fund. The lower the credit rating of the organisations, the more we should diversify. As a general principle, we don’t want to put more than we can afford to lose into any single investment.

If you like the sound of junk bonds then it would be sensible to spread the risk much wider. It is a cardinal rule of economics that high returns are what you get for taking high risks. Roughly speaking, if a junk bond offered a return double that of a government bond, then you could expect maybe a third of the junk bond issues to default. If the market (or the credit rating agency) has got it right, then the probability is that what you gain on the swings you will lose on the roundabouts. In other words you might reasonably expect to do marginally better by going high risk than playing safe; if you are lucky you will do a fair bit better; if you are unlucky you will do worse.

To summarise, the risk to our capital with fixed interest investments and savings accounts rests on the question of whether the organisation that has our money will fail. In effect, the risks to income and lump sum come from the same source. We can reduce the effect of default by spreading our investments across several investments.

Investments that are market-based carry another type of risk, and that is the subject of the next page.

 

  9 October, 2008 © 2008 K.R.Wade and Co Ltd prev page next page