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As returns from money market instruments on both side of the Atlantic
remain close to zero, most economists and investors are starting to
accept that the current low interest rate regime is here to stay, most
likely well into 2010 and possibly beyond.
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Even after taking into account the balancing effect of the general low level of inflation, keeping money in cash pays so little that even the most risk adverse investors are starting to turn away from the security of traditional safe haven investment for the possibility of earning a higher yield on riskier investments.
Many options are available to investors who seek to capture a return that represents a premium over available cash rates. However, they all come with some increased levels of risk.
The key for investors is to decide what is acceptable risk according to their needs and preferences, and make investment decisions in the context of their overall portfolio.
Here are some simple investment strategies open to investors.
Locking up your money
There is a large liquidity premium currently available to investors who are willing to lock up their money for the long term. Even bank deposits will pay up for investors who can lock in their money over a longer period of time (generally up to 5 years). Other asset classes reward investors with a liquidity premium, such as Real Estate and Private Equity. However, investors need to consider that giving up the chance of accessing their money may end up being a sacrifice in the long run.
Adding counterparty risk
This is generally achieved by moving away from diversified funds and treasuries and investing in bonds. With traditional corporate bonds, investors obtain yield enhancement by lending their money to a corporate and taking the risk that the corporate may default and fail to return their money at maturity. Given a set investment period, the level of yield enhancement will depend on the perceived riskiness of the corporate issuing the bond.
Banks also issue bonds, which are not covered by any Deposit Protection Scheme and therefore carry more counterparty risk than fixed deposits – but are substantially more liquid too. An example of this type of bonds are Barclays Fixed Rate Notes. These are debt obligations issued by Barclays Bank Plc, paying a fixed interest rate over a medium to long term. Investors benefit from the premium awarded for entering into a fixed rate investment. However, investors need to consider that interest rates may not stay low forever and any upward movement in interest rates will negatively impact the market value of their investment. In other terms, their capital will be returned in full only if they retain the note to maturity. If they try to sell it earlier they may be offered an amount lower than what was originally invested.
Adding market risk
There are many types of market risk available to investors who are looking for yield enhancement (Foreign Exchange, Equities and Commodities are only a few examples). Most investors access these types of market risk through simple directional trades, such as buying shares or entering into an FX forward contract. However, they can be accessed through the use of derivatives, such as options or swaps, to create different blends of risk and return according to investors’ preferences. Here are some examples of investment strategies that include one or more types of market risks:
Double Currency Units (DOCUs) – also known as Dual Currency Instruments (DCI), these are certificates linked to the movement in the exchange rate of a currency pair. Investors obtain a premium for accepting the risk that their funds may be redeemed at maturity in the alternative currency and converted at a predetermined exchange rate. Dual Currency Investments are suitable for clients who are indifferent as to which currency they hold and don’t mind potential conversion at the pre-determined rate, who have a foreign currency requirement or have a directional currency view.
Protected Equity Linked Note (PELS) – these notes offer repayment of capital at maturity and participation to the positive performance of one or more equity indices up to a pre-determined maximum. These are suitable for investors who are looking to take diversified exposure to equities and are willing to give up some of the potential upside in exchange for repayment of capital at maturity whilst accepting the risk of loss on early sale.
High Coupon Notes on commodities –these short term notes pay an enhanced guaranteed coupon significantly above available cash rates but the repayment of capital at maturity will depend on the performance of an underlying commodity or basket of commodities over the term of the investment. Investors in these notes benefit from potentially high returns in scenarios of neutral or moderately rising commodity prices but are exposed to risk to capital in case of adverse price moves.
There are countless other examples of investment strategies that may be appropriate in the current climate. Venturing into uncharted territory does not need to be too risky either. There are plenty of defensive strategies for investors with low appetite for risk.
The best advice for investors is to investigate the options available and ask questions, remembering that given the likely scenario of a prolonged period of low interest rates not taking any action may also carry a hefty cost opportunity.