Risk Assessments

I have spoken to a lot of people over the last few months regarding our Fixed Rate Deposits (http://www.fixedratedeposits.com/) and it is apparent that there is a clear case of poor analysis when it comes to determining the risk of a product.  Assessing risk is difficult at best and sometimes almost impossible, but in the main it is relatively easy to compare products and get a clear sense of whether the added return validates the increase in risk.

A risk assessment starts with the least risky asset of all the United States T-Bill.  This is a highly liquid note and has the full faith of the United States Treasury behind it.  At present that is worth something and as long as the perceived security is there then it holds its place as the least risky of all assets.  At present the one month T-Bill is yielding 0.03% or basically nothing.

From this low level rates start to increase with risk.  For an indication the 10-year T-Bond is currently yielding 3.18%, so a lot higher return for a lot longer term.  As the longer term means a higher probability of not being paid back the risk is higher.  Some may argue that there is still no risk as the investment has the full faith backing of the US government, but we have seen just how much of a mess can be created in just a few years, so I would say that there is a higher risk associated with the longer term and this is reflected in the increased rate.

So the higher the risk the higher the return?  Not in all cases.  There are many cases where the risk is far higher than the return and other cases where the return is far higher than the commensurate risk.  The latter investment is what every investor strives to find and what I strive to create.  So with the basis of the above two rates from the US Treasury we will now go to the next step of risk analysis - a comparison of four products and our Fixed Rate Deposit.

The first comparison is to a bank Certificate of Deposit.  The bank rate for a two year CD is around 1.50%.  Compare this to our current two year rate of 4.00% and it would appear that the risk should be a lot higher for the Fixed Rate Deposit.  The bank comes with FDIC insurance to $250,000 ($500,000 if you are a couple or a trust) and the backing of the financial institution itself.  The Fixed Rate Deposit has the backing of the schools and the funds protecting it.  I would argue that the risk profiles are similar as the Fixed Rate Deposits has never had a default in over 8 years while banks are failing left and right and the FDIC is pretty much insolvent.  Furthermore I would contend that most banks are insolvent as they are not required to mark the assets on their balance sheets to market.  Hence a mortgage that is current but attached to a house that is worth less than the mortgage is considered a performing loan and listed at par.  If the mortgage was marked to market it would have to be written down to the value of the property and this would instantly (in my opinion) make most US banks insolvent instantly.  The Fixed Rate Deposit investment has the backing of very solvent and highly profitable institutions.

International banks are offering higher rates than those on-shore.  Banks in the Philippines and other emerging economies can offer rates of 2.5%.  While these banks are US based they are still subject to sovereign risk.  So while the investment may be held in dollars, if there is a coup or a nationalization of the the banking system these assets could be lost.  Certainly countries such as Australia and New Zealand are considered safe bets, but I would steer away from the South East Asian rim, South America, the Middle East and Africa.  Once you strip those away you are back to poor rates of return in developed countries.

Now on to another comparison.  I have had money managers mention that they receive higher rates than the rates on the Fixed Rate Deposits.  One investment is an exchange traded fund (ETF) with the ticker CEW.  CEW is made up of a basket of emerging country currencies.  This basket of currencies has provided a return to investors of roughly 5% per year.  As it is an ETF there is daily liquidity but you are really dealing with fire here.  Remember 1997?  Contagion spread throughout the world and emerging country currencies fell like stones.  If this ever happens again (and I predict that it will) these investors will all run for the exit at the same time and will drive the value of this ETF through the floor.  Is this huge risk worth 1% more?  I think not and certainly it is not an investment that I would consider for my safe money.

The final comparison is structured note products that are in vogue at present.  These investments yield around 7 to 8% however there are a lot of caveats.  First is the underlying collateral of the asset.  These notes sell puts against various markets.  Typically the puts are sold way out of the money but the product is open to risk.  As you now know a put is an option that allows the seller to sell their position in a stock or an index at a preset price.  If the market falls below that price then the seller of the put transfers ownership of that index across to the buyer and the buyer is on the hook for the asset at the preset price.  Now these options are sold well below the market but should the market collapse the owners of the structured note could get wiped out.  Second are the large commissions that are paid to the brokers of the structured notes.  No wonder they peddle them so hard and even sell them as "risk-free".  This is hardly a risk free investment especially when you consider that the term of the note.  These notes typically have a relatively long term hold on them.  If you wish to exit there are fees and penalties that will eat up any gains, so the owner of the note has to sit and wait for 6 to 12 months and hope that the market continues higher or risk losing their entire investment.  Certainly a much greater risk than anything I have to offer and in my opinion not worth the extra 3%.

These are just four examples of different styled investments. Each has a different risk profile and each has a different rate of return.  As an investor you need to carefully analyze the risk of the investment before committing to the investment based on the sales pitch.  If after careful analysis you are comfortable with the investment then proceed, but make sure that you compare your proposed investment with other investments to really understand the risk of each and the proposed return and strive to invest in those with the least risk and the greatest return.