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Safety in numbers

Is there such a thing as a guarantee for your investments? While capital protection sounds like a pretty good idea, what does this class of investment product really offer? To demystify the issue and sort fact from fiction, Peter Switzer spoke to Susan Salter, head of structured investment at the Commonwealth Bank (CBA), on his Sky News Business Channel Program, SWITZER.

Protect yourself

Everyone loves the sound of the words ‘capital protection’ and they also love to have massive returns – but is it possible, Switzer asks, for the two to happen at the same time?

“It depends how you quantify massive,” says Salter, adding there is the potential to improve on the risk-free rate set by the bond market for term deposits. A structured protected investment, she says, offers you capital gains at a fixed date, which is generally the maturity date, but instead of giving you a known return, another structure is embedded – the return can be linked to, say, the share market or to the price of gold.

“So if, in fact, the share market or the gold goes up, we could expect, say, two, three or four times more than what you would have received on a classic deposit,” Salter explains. “But that assumes, of course, that the underline goes up as we plan.”

Growing interest

Capital protection is nothing new, but the recent local economic shake up has seen its popularity on home soil grow.

“We’ve had a very strong bull market here in Australia so investors might think, ‘well, I don’t need capital protection’. That’s probably been the learning experience of the last year – what does go up, can go down.”

So, just as people buy insurance for their greatest assets – their home, their car and their income – now they are also looking to protect their shares. Still, Switzer says, confusion remains in the fact that some products come capital guaranteed, some come capital protected. So, what’s the difference?

A guarantee, says Salter, applies if there is a third party involved backing the issuer, such as the current government-guaranteed bank deposits. This offers an additional layer of contractual arrangements. A second safety net, if you will.

Most products, though, are capital protected by the issuer.

“For example, if you buy a capital protected investment issued by CBA, you’re taking the basis that CBA will be able to uphold its obligations and that’s what’s going behind the capital protection,” explains Salter.

When it comes to capital protection, then, it’s important to consider who you’re trusting your money to. While the Big Four and many of the smaller banks offer such products, so too do other financial institutions, so doing your homework is crucial.

“The offer of capital protection is only as strong as the balance sheets and the bank’s ability to actually uphold those obligations,” says Salter.

It’s important, says Switzer, for investors to be aware of this risk.

Salter agrees: “I think they do need to look at the balance sheet and look at the credit rating of the issuer, most definitely, because the value of that capital protection is only as strong as that credit worthiness.”

Products on offer

The CBA offers two categories of products. In the first, the first is an alternative to a cash investment.

Salter explains: “We’ll strip out the interest and any interest will be invested into an underlying asset, so, like I said earlier, the share index or gold, and you mush them together – that’s my very technical word. The end result is you’ll get your money back because you have the embedded bond structure, and you’ll get the performance of the underlying asset because there’s a derivative involved.”

The second is slightly more complex – a split loan structure.

“We’ll invest into the share market for the clients and we’ll sell him an insurance policy or put options – so again, a derivative – to help mitigate that risk – and it’s often combined with a loan.”

In this instance, Salter says, you’re able to gear into the share market while having the advantage of the capital protection, and no margin calls and you still get the dividends and the franking credits.

And what kind of time period are we talking about?

“Most clients go for three to five years, but they could have six months if they like, they can have one year,” says Salter.

Economic outlook
We are, Switzer says, at an intriguing point in the market.

If you side with the bulls and their V-shaped recovery, a capital protection product provides a low risk option in which you reap the benefit of the market’s gains. 10 March, he wryly observes, would have been the ideal time to come to such an arrangement.

But if you are bearish and believe the W-recovery is what’s in store, you may be disappointed, despite the capital protection.

But that’s not all investors need to consider – it applies per share, so there is no dilution effect.

“So if you’re just going to go into the market, the capital protection actually applies to each share, so you get to keep the upside of the shares that perform well, and if the share performs poorly, you can hand it back to the bank as an extra payment for the loan, so there’s no dilution.”

If the product consists of the two parts – the capital appreciation and the dividends, what happens to the dividends?

“They go the borrower as part of the loan and the franking credits as well,” says Salter.

Who does this suit?

Salter says those who opt for capital protected investments generally fall into two categories: those whose motivation it is for the dividends to reduce the price of the loan, and those who want to take risks without, well, the risks.

“They’ll choose the stocks they normally wouldn’t go into – having the protection provides the upside.”

The cost, though, accommodates this safety net. Salter says for a five-year loan, fully capital protected, you’re looking at around 10 to 11 per cent per annum in interest.

“Some clients say, ‘Oh, that’s quite a lot’, but what we encourage clients to understand is the assets protects clause, so while you’re paying that 10 to 11 per cent per annum, you get the dividends, you get the franking, you get a deduction on the interest which brings the after tax cost down to, let’s say, three to four per cent. So, in fact, your after-tax cost will be lower because the stocks have to go up by that amount for you to actually make money.”

These kind of products, though, are not designed for those looking to trade.

“It’s more a buy and hold,” says Salter, adding there are costs associated with switching stocks and she wouldn’t recommend this product to anyone looking to do this.

“Protected lending’s been around for a good ten years,” says Salter. “It’s quite straightforward: if the stocks perform well, these products perform well.”

Let’s hope, says Switzer, the market keeps going up.
“Yes,” says Salter, “That’s in everyone’s interest!”

For advice you can trust, contact Switzer Financial Services.

Important information:This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

Published on: Monday, September 07, 2009

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