FOOL'S EYE VIEW
High-Risk, High-Income

By Maynard Paton (TMFMayn)
November 7, 2001

Carburton Street, London -- Inspired by declining stock markets and falling interest rates, investment companies are busy promoting high-income products. As one such company asks:

"Unsettled stock markets may have put you off share-based investment. But with interest rates so low, where could you go to get a good return without excessive risk?"

With the financial press full of adverts for high-income products, it's worth going over some of the basics. And here's the most basic of points: Any high-income product stating that it can yield a higher rate than that offered by government bonds (gilts) -- currently around 4.5% -- has the genuine possibility of reducing its  income yield and/or the investor's underlying capital.

Unfortunately, the potential high-income pitfalls tend to be glossed over or obscured through complicated product design. Certain high-income products can leave the traditionally cautious yield-based investor taking on far more risks than he or she ever intended.

FSA

The first port of call for prospective purchasers of high-income products is the Financial Services Authority website. The FSA has highlighted its own concerns over the marketing of these products. In this document (Adobe Acrobat required), the FSA outlines these key points:

* The value of your capital can fall below the original amount you put in;

* Some products are designed to give you the maximum benefit only after a set period -- often five years;

* The higher the promised rate of return, the more likely it is that your money will be put into risky investments, and;

* The rate of income you see advertised may not be paid unless certain specific conditions are met. It will not usually be guaranteed.

There are many different ways for financial product providers to generate "high income", the use of corporate bonds or plain old high-yielding shares being two popular methods. However, in the fight for the greatest "headline figure", investment companies are resorting to esoteric methods to generate just that little bit extra. Unfortunately, high-income products using complex financial instruments are becoming increasing commonplace.

A recent report issued by Deep Blue Financial highlights how derivative-based high-income products tend to work. Contributions are essentially split into two parts. The first part is used to underpin a 100% return of capital. For example, if you invest a total of £100, between £75 and £80 will be placed in a fixed-interest investment that will return (at, say, around 4-5% a year) the original sum in five year's time.

Derivatives

The rest of the contribution is "invested" in derivatives. The investor's "excess" income is thus based upon the performance of the derivative, which in turn is linked to the performance of various stock market indices or "baskets" of shares.

Apart from the obvious perils of effectively owning derivatives, a notable problem with the above set-up occurs if interest rates continue to fall. In such circumstances, a greater proportion of the £100 would have to be placed on deposit to return that £100 in five year's time. That leads to less money being placed on the derivatives. And to keep a decent headline figure in those adverts, so more derivative risks have to be taken.

With that in mind, rather than use a five-year time horizon (a period typically set as a minimum for equity investors), product providers are gradually shifting towards shorter product timescales. Moves to three-year periods, while inherently increasing the derivative risks and their volatility, do reduce derivative costs for the product provider.

Capital loss

As the FSA has stated, the rate of income advertised on high-income products may not be paid unless certain specific conditions are met. This is certainly the case with any derivative-based product.

Thus you may find your income is linked to the performance of various global stock markets. Some products, in their quest for outperformance, attach themselves to more volatile markets, such as the Nasdaq Composite. Other products rely on groups of specific shares. But whatever the underlying derivative used, if the indices or shares fail to perform as expected, then the investor can suffer significant capital losses.

The possible downside varies between products. Some products will reduce the investor's capital in line with the linked index. But others will have a gearing element. For instance, on one particular product, you'd still receive 100% of your capital if the linked index fell no more that 10% over the product's term. However, should that index have fallen over 10%, then every 1% index decline leads to a 2.5% capital reduction. Needless to say, how you judge the "risk versus reward" equation of such a product is no easy task.

Summary

It's worth reiterating two key tenets of sensible investing: "Keep it simple" and "If it looks to good to be true, it probably is". Foolish investors need to keep their eyes wide open when evaluating high-income products. Certainly those products that look to have appealing yields, but also have unusual or complicated conditions, must be treated with circumspect. Products that offer income that's linked to the performance of a stock market index, or equity-based products with sub five-year terms, all have great potential to disappoint low-risk investors.

More: Yield Not Unto Temptation