With interest rates for savers falling further last week it is only natural that anyone who has previously relied upon interest payments to partially fund their lifestyle or generate growth for future income will now be looking for better returns.
And better returns are potentially available through a whole host of product types, including structured products, indexed deposit accounts, corporate bond unit trusts etc, etc. But those higher potential returns, inevitably, come with a higher risk profile and it is crucial to ensure that clients are made fully aware of all of the risks which they may face when looking at alternatives to deposits. We have tried to highlight some of the features and pitfalls to be aware of in this article.
Corporate bond funds
Corporate bond funds (accessible via stocks and shares ISAs, OEICs, unit trusts) have been making headlines recently with higher interest rates compared to deposit accounts. It is now possible to switch a cash ISA paying low interest to a corporate bond (stocks and shares) ISA. However, before considering an investment into a corporate bond fund (or an ISA switch) it is very important to remember that the capital in a corporate bond fund is not secure, and while a switch from a cash ISA to a stocks and shares ISA is available – the reverse is not possible.
The higher yields currently available on corporate bonds are a natural consequence of recent falls in their price which have been fuelled by investor worries over the ability of issuing companies to maintain interest and debt payments. The question is whether the yield available compensates adequately for the risks?
Bear in mind that different corporate bond funds will have differing investment strategies. So, it is important to be aware that the higher the potential income from a corporate bond, the greater the risk of the company defaulting.
Share prices have decreased rapidly, resulting in rising dividend yields. Bear in mind the fact that the average yield on UK shares is quoted net of 10% tax and will therefore only represent a true figure for those who don’t pay higher rate tax (including non taxpayers). For those paying 40% tax there will be an additional income tax liability of 22.5% of the gross dividend payments.
Also remember that quoted dividend yields are usually based on dividends paid over the previous 12 months and there is obviously no guarantee that dividend payments will continue at the same level. In fact it could be said that it is more likely that dividend yields will fall.
Those purchasing shares at the moment, either directly or via collectives, may be buying in at the bottom of the market (although calling the bottom is only possible with hindsight) and therefore hopefully, providing the investment can be held for the longer term (5-10 years minimum), they should reap the benefits of this in terms of capital growth. Clearly there is no guarantee of this and, as we well know, share values can fall as well as rise!
The income from overseas equities has also increased although the absolute level is usually lower than with UK equities. It is important to be aware of the investor protection available in the country of investment and how this compares to the UK position.
Capital Protected/Structured Products
In one form or another, such products offer a return linked to a stock market index but with capital protection at the end of a fixed term. There are various products on the market from time to time and each must be carefully considered on its own merits as the conditions attaching to full capital repayment vary widely. Particular care should be taken to recognize the importance of any counterparty and the problems which their failure could cause.
Late last year the Financial Services Compensation Scheme (FSCS) cover for deposits with UK banks was raised to 100% of the first £50,000. In addition, the Government decided to provide individual depositors with unlimited protection for their savings in particular banks, including Bradford & Bingley and Icesave. Clearly, it would be dangerous to assume that the Government would take such action again.
Remember that, generally (see below), the improved £50,000 limit applies per banking license, not per bank, and this becomes more of an issue as banks merge but keep their previous names. The FSA has announced a temporary exception when building societies merge whereby if the merged societies continue to operate under their previous names, then until September 2009, the £50,000 limit will apply separately to pre-merger accounts.
There have been no changes to other FSCS compensation limits or rules (see table below).
|Deposit accounts||£50,000 per person per licensed bank|
|Investments (eg unit trusts, OEICs)||£48,000 per person per investment firm:100% of first £30,000 and 90% of next £20,000|
|Long term insurance (including investment bonds)||No monetary limit100% of first £2,000 plus 90% of balance of claim|