In the investment world, the rule of law starts from the very simple concept of risk and return – no pain, no gain. When investors are making investment decisions, they are trying to assess whether the investment return is commensurate with the investment risk. Their starting point would be the risk-free rate of return. Traditionally investors would look at the sovereign yield and work their way up to create a hypothetical scenario which mirrors their current investment opportunity. Other risk factors would be taken into account, such as liquidity risk, credit risk, duration risk, etc.
Choosing to hide behind the Depositor Compensation Scheme should not be the route of least risk to take with your funds
Until very recently this methodology was only applied to bond investments and hardly ever to bank deposits. Furthermore this analytical approach was possibly deemed unnecessary given that a depositor compensation scheme was adopted whereby deposits, up to €100,000, are insured by this scheme.
In the meantime, bonds as an asset class are still yielding very little. Investors would need to invest in (at least) 10-year, investment grade, corporate paper to return a real yield (that is, net of the inflation rate). Alternatively, they would have to go outside their risk comfort zone and consider investing in sub-investment grade bonds (that is, bonds with a rating of BB+ or lower) or even equity to receive a more meaningful return.
However, this increase in return is a direct result of an increased exposure to investment risk. This is where the problem starts. I have recently started to see a change in the investors’ mindset. The question they pose is: what sense does it make to buy a five-year, investment grade, corporate bond yielding two per cent per annum when I can deposit the funds in a five-year bank account and earn four per cent or more per annum. Apart from the issue of liquidity, investors see no rationale to invest in the bond instead of the bank deposit.
The Cypriot scenario may be the answer for them. Although Cyprus’s problem seems to have been solved by the European Super Heroes (ESH), the ripple effect created while getting to the solution is still around and investors should take note. One of the solutions being considered at the time included a tax on all deposits including those below €100,000 which should be covered by the scheme.
Even though this route was not chosen, make no mistake, if the ESH want to circumvent the Depositor Compensation Scheme they will definitely find a way of doing so. The words ‘depositors’ and ‘investors’ are starting to be used interchangeably and that is, to a very great extent, wrong.
On the other hand, even the nature of banks and bank operations is changing. Traditionally a commercial bank would borrow money from depositors and loan money to individuals and businesses and make money on the interest rate differential. However, more recently we are also seeing a widening in the ‘scope’ of commercial and retail banks and it is this wider scope that has introduced a new range of risk variables which are too often ignored by the retail investor.
Investors and/or depositors need to be aware of the ‘operational’ risk their deposits are exposed to. Banks (whichever category they would fall under) do not pay higher interest rates as a sign of goodwill and depositors need to, at least, be aware of the risks they are exposing themselves to when depositing with one bank versus another.
Bank deposits have, more recently, been considered to be risk-free ‘investment’ alternatives by the less educated investor and this is completely inaccurate. Depositors and investors should ask themselves whether they would still use the bank/s they use even if these were not covered by the scheme.
Are they comfortable exposing their deposits to the operational risk of the institution they chose to bank with? Choosing to hide behind the Depositor Compensation Scheme should not be the route of least risk to take with your funds. On the contrary, the idea of holding a low yielding, investment grade, corporate bond should be given more thought.
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Curmi & Partners Ltd is a member of the Malta Stock Exchange and licensed by the MFSA to conduct investment services business. This article is the objective and independent opinion of the author. The value of investments may fall as well as rise and past performance is no guarantee of future performance.
Karl Micallef is an executive director at Curmi and Partners Ltd.