Editor’s note: This article was first published in October 2011. The deposit rates, government debt yields, CAM’s suspension of interest on subordinated debt, Santander convertible bond losses and expected bank capital increases describe Spain then; CAM was taken over by Banco Sabadell months later.
With market volatility and the banks’ need to bring in new money, conditions are improving again on the most basic investment products for the most conservative investor. As usual, though, we have to examine the small print in the contracts we sign at the bank and, above all, learn to tell apart some concepts that sound safe but don’t guarantee the expected return.
As things stand, the safest investments at this stage of the crisis are bank deposits and bank promissory notes. You need to be very careful with both products, because, as a rule, the higher the return, the more small print there is.
Deposits and promissory notes
At first glance, a fixed-term bank deposit pays more than investing in promissory notes, and it also requires a smaller cash outlay.
Today you can find very good deposits paying more than 4% APR over 12-24 months, and there are even some at 4.80%. Before putting money into a deposit, we should run away from that thing called “tie-ins,” because taking out a high-interest deposit is not much use if you are obliged to take a credit card or to transfer a certain amount of money into a pension plan for a certain period.
The bank employee will tell you that you lose nothing with this type of deposit, quite the opposite, since you’re saving even more for your retirement. What they won’t tell you is that a pension plan is the least profitable investment product there is, because until now it has fallen well short of inflation. Everyone who had a pension plan in 2000 has lost money.
So if you invest in a deposit, it must not come with any tie-ins.
As for promissory notes, they usually pay a similar return to a bank deposit, and the risk is even the same, practically zero, except that a promissory note isn’t covered by any guarantee fund, whereas with a deposit you are covered up to 100,000 euros.
“This reminds us that if you are going to invest more than 100,000 euros, don’t put it all in the same bank. Spread it across different banks, and that way your whole investment is insured.”
To invest in promissory notes you need at least 6,000 euros, although as a rule much more initial capital is required for this product.
Given that the requirements for investing in promissory notes are higher, you are not covered by the deposit guarantee fund and the return is the same or lower, the more profitable investment is of course the fixed-term deposit, as long as there are no tie-ins.
Other products sold as safe investments that don’t give you security
Convertible bonds and subordinated debt
As we said before, showing financial ignorance is like writing the bank a blank cheque. That’s why, when an inexperienced saver or investor goes to a bank looking for a safe investment product, the bank, depending on its scruples, will sometimes try to sell them convertible bonds or subordinated debt as fixed-income investment vehicles.
In many cases, the customer leaves the bank thinking they will be able to get their money back whenever they want, and that is far from the reality with these products, because the coupon payments usually come with a clause: they depend on the bank making a profit. If the bank doesn’t make a profit, it can stop paying them, perfectly legally, because that is what you signed.
In the case of subordinated debt, we have a recent example in CAM (Caja de Ahorros del Mediterráneo), which announced it was suspending the quarterly interest payments on its subordinated bonds after posting losses.
As for convertible bonds, we have the example of Banco Santander. When investors buy convertible bonds, some don’t realise that it is as if they were putting part of their investment directly into Banco Santander shares. Anyone who invested in Banco Santander convertible bonds and decided to get their money back today would find losses instead of gains, because the bank’s shares have fallen sharply on the stock market. This product, sometimes sold as a safe investment, is in fact a very high-risk product and not suitable for a conservative investor.
What’s more, the banks will probably go through capital increases, and that process affects investors holding any kind of bank product except deposit holders.
Government bonds and debentures
This is a good option for a conservative investor, because it is a safe investment. The problem with investing in government debt right now is that the return is lower than on deposits and you have to keep your money in for longer. It is a highly recommended investment for the patriotic investor, because, as we argued before, with a deposit you generate profits for the bank, while by buying government debt you generate income for the government. In terms of return, for now it is lower.
Steer clear of the word “funds”
It doesn’t matter how they dress it up. If an investment product has the word “fund” in its name, it carries a risk that you don’t control and that is in the hands of a third party.
Since some customers are now wary of investment funds, funds are often dressed up with words like “guaranteed fund,” “mixed fund” and so on.
Well, the first time I asked an investor what a guaranteed fund was, he replied: “A guaranteed fund is a way of investing without any guarantee, because they usually give you a return below inflation, and a mixed fund is a chance to lose money you could have invested yourself.”
A guaranteed fund offers you an interest rate of 7, 8 or 9% in big print. The small print says you are only guaranteed 0.25, 0.50 or 1%, rarely more.
A mixed fund is one that invests part of its capital in fixed income and the rest in equities. Even if 70% is invested in fixed income, that is enough for the fees on the equity portion to eat up the interest earned on the fixed-income portion. Before investing in any kind of fund, seriously consider investing in the stock market yourself; that way, if anyone loses the money, at least it will be you.
To sum up: the only safe investments we have are fixed-term deposits, promissory notes and government debt, and of these three options, the most profitable for now is still fixed-term deposits (until new options come along).
Further reading: Investing in the stock market: a beginner’s guide
Featured image: Mark Hunter, CC BY 2.0, via Flickr.
