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Equities

Investing in Equities

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Investing in equities, stocks or shares all refer to the same thing – being a part owner of a company as a shareholder and participating in the profits and losses of the company(ies) you invest in. There are two main ways of making money when investing in equities:

  1. Capital Gain
  2. Dividend Income

With respect to capital gain this can be done in more than one way. The simplest form is to buy an equity at a low price and then sell it at a higher price. However, one could also short an equity. The desired result is still to sell high and buy low, but instead of first buying the equity and then selling it the process is done in reverse. Thus, if one would expect an equity to fall in price one could sell the share (by essentially borrowing the shares from one’s broker) and then buy them back at a later stage.

The risks associated with shorting are higher than the traditional way of buying and then selling later (known as “going long”). The reason is simple – if one buys €10,000 worth of shares the maximum one could lose is their €10,000 since a share cannot have a negative price and go down to €0 at most. In the case of shorting however the downside risk is much bigger. For example, if I sold €10,000 worth of a share at a price of €100 per share – so I would have sold 100 units (€10,000 divided by the price per share of €100) and the price subsequently skyrocketed to €250 per share and I was forced to close my position I would have to pay 100 multiplied by €250 = €25,000 to buy those shares. So deducting the €10,000 I would have gotten when I would have shorted the same shares, I would end up with a loss of €15,000, which is higher than the original amount I traded.

The above example is simple way to see the difference between the two methods of going long and of shorting. However, they are very extreme cases and are not as likely to happen. This is not to say that a company cannot go bankrupt (example after a major scandal) or cannot have its shares price skyrocket (example after the announcement of a takeover). However, through some simple risk management techniques such as sticking to the larger capitalised stocks and investing a portfolio of different shares, such extreme cases can be minimised and their impact on your overall wealth can be reduced significantly.

Can equity investing be profitable?

The easiest way to answer this question is to look at a broad-based index such as the S&P 500 which is a US stock market index based on the market capitalisations of 500 large companies having equities listed on the NYSE or NASDAQ.

The chart below shows the performance of the S&P 500 over the last 5 years from 5 April 2012 to 4th April 2017

*Source: Google Finance

As can be clearly seen form the above chart the performance over 5 years of this equity index has been 67.57% equating to a 13.514% return per annum. Thus, it is true that double digit returns are still possible on equities and it has been the case for the last five years, based on real figures. What if we increase the time frame, perhaps the last 5 years were exceptional? The chart below shows the same S&P 500 index but over a 10 year period from 5th April 2007 to 4th April 2017. Hence, it also includes the latest major financial crisis:

*Source: Google Finance

Some interesting points to note:

  • The 5 year and 10 year return on the same index are very similar which means that the annual equivalent of holding the same index for 10 years was 6.611% per annum (i.e. around half the last 5 year annual equivalent).
  • The price can go down and it can go down significantly. Anyone who bought at the highs of 2007 and was panicking in early 2009 and decided to sell could have lost around 50% of their investment.
  • Investing in shares is a long-term game – the same person who invested in the highs of 2007 and decided to hold on to their investment would be gaining 66% currently.

Does this mean that one should always invest in a broad range of equities such as buying an index fund that tracks the S&P 500 in a passive way?

Not necessarily. Increasing the amount of equities within one’s portfolio is a good thing only until a certain point. Diversification (the lowering of risk by spreading the investment across different equities) will be a positive factor, however the amount of gain through diversification is reduced further and further the more equities one adds. One must consider that although increasing the amount of equities lowers the impact of the negative trades, it also reduces the impact of the positive trades. Furthermore, one also should consider other factors such as transaction costs and costs for maintain the portfolio. The smaller the amount that is invested per share the larger the cost since most brokerage firms will have a minimum cost per share and some also have safe-custody fees which is a fee for holding the equity on your behalf.

Another factor to keep in mind when analysing the example above of investing into the S&P 500 is that we were just considering the more traditional method of investing buy buying and holding in a passive way. In the example, the investor would have bought at the begging of the period considered, left the investment running without any intervention, and then sold at the end of the period to make the capital gain. If we had to take a closer look at the ten year chart however it is clear to see that there were opportunities to make more than 66% by for example shorting the same S&P 500 between 2007 and the first quarter of 2009, by going long again from 2009 to the first quarter of 2010 and selling off again.

This method of investing is called active management where an investor would try to anticipate market movements and earn returns above the market rate. Of course, we have the benefit of hindsight in our simple example so it would not be that easy to outperform the market. However, there are methods that exist that attempt to analyse the past patterns and directions of equities with the aim of anticipating future movements. Technical analysis is all about building models and trading rules based on observed price and volume changes. Back testing is regarded by many as highly relevant to creating models and algorithms that can trade equities in a long term profitable manner and in fact outperform the market.

The Bottom Line

The aim of this post was to give a general introduction to equity investing. Locally, many investors tend to shy away from equities and they prefer fixed income investments such as bonds and bond fund since they pay more reliable regular income. However, given the interest rate scenario, which I have made reference to quite a lot in my previous posts, one has to be careful of the interest rate risk present in bonds and bond funds. Adding an element of equity investment to a portfolio could help mitigate the interest rate risk and diversify one’s portfolio to be positioned better for the months and years to come. There are different ways of investing into equities and I will be uploading more posts in the coming year which discuss such methods. One of the most advanced methods of investing into equities is through algorithmic trading. Anyone wishing to read more about this method should see my previous post here.

As usual, please refer to the normal disclaimer.

 

Other

Algorithmic Systems Trading – The Modern way of Trading

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Algorithmic Systems Trading is sometimes confused with some impossible to understand formula that is too complicate to trust. In reality it is just a fancy way of describing the combination of trading using the advantages of computers, mathematics and statistics. It is a scientific approach to investing based on technical analysis and is typically characterised by many trades held for short periods of a few days. Thus, using what is called the law of large numbers, enough wining trades will end up outweighing the losing trades leading to a positive return for investors.

Is this high level of trading available to everyone?

An initial concern investors may have is that this type of high-end investing would only be available to high net worth clients having millions to invest. In reality companies like Novofina which are so called FinTech (Financial Technology) and WealthTech (Wealth Management through Technology) companies make this type of investing available to investors willing to allocate at least €30,000. These sort of companies are bringing high-end investing previously reserved just for elite clients to the retail space.

Novofina, which is licensed by the Malta Financial Services Authority, applies algorithmic systems trading to investing in US large capital stocks, the so called blue chip companies. These are the largest companies quoted on the US stock markets, companies like Amazon, McDonalds, Apple, Exxon Mobil and the like. The company combines different systems that trade based on different criteria such as stochastic systems, Bollinger bands and other technical analysis schools. It combines these different strategies to make up its two main products which clients can invest into. So as opposed to trying to invest on their own based on some gut feeling or long term expectation that may never come to fruition clients get access to cutting-edge computer based equity selection. Best of all the systems operate on their own without the need for client intervention except to decide on how much to invest and what level of risk they are prepared to take on.

Is this a get rich quick scheme?!

Definitely not. Investing in shares has historically been the best form of investment time and time again. However, it is still a long term investment for clients having a minimum 5-year investment horizon. Looking at the returns on equities versus bonds (gilts) versus retail prices between 1899 and 2011 (thus including the great depression, the world war periods and the 2007/09 financial crisis), as reported by Barclays Bank, it is clear how much better off equity investments are over the long term:

By investing smartly into the equity market using such systems employed by Novofina you will not turn €50,000 into €500,000 within a year. That sort of return is not sustainable and would be too risky to attempt to achieve in a short period of time. Nonetheless, turning €50,000 into €500,000 over a ten year period for example is very much possible. This is particularly interesting given the current interest rate scenario whereby we are finally starting to see central banks increase interest rates following a prolonged period of virtually 0% rates. Keeping in mind that prices of bonds move inversely to interest rates, should there be an indication that the European Central Bank could be increasing its base rate all local bonds (especially the longer dates ones) would suffer a fall in price. We have already started to see some “risk-on” movement with the prices of Government Bonds across the EU countries falling in price. This appears to be happening due to an improved appetite for risk whereby investors are selling their government bonds and opting for investments that are perceived to be riskier, such as shares.

Therefore, considering a shift into an equity based investment such as the algorithmic systems based products mentioned in this post could prove to be a well-timed investment decision. Adding equities to one’s portfolio has been proven historically to offer a better balance and overall higher average return. By doing it wisely, using statistically proven methods which are objective as opposed to a human traders’ subjective tendencies, one has a better chance of managing the downside and benefitting from the upside.

The Bottom Line

Algorithmic systems trading is nothing to fear and is based totally on statistical real returns. It is considered by many to be the best investment method available since it uses the latest stock-selection methods which consider many important characteristics of trading successfully such as entry points, profit targets, maximum holding periods and batch sizes. Combining all this and achieving lower risk through diversification of the investment portfolio should prove to be a long term winning formula for any investor. Best of all, such products are already available locally through Novofina starting from a low minimum investment of €30,000.

* This post was issued by Kyle Debono, Managing Director and Portfolio Manager at Novofina Ltd. The information, views and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice. Novofina Ltd has not verified and consequently neither warrants the accuracy nor the veracity of any information, views or opinions appearing on this link. Please refer to usual general disclaimer here.

ForEx

Foreign Exchange Risk: Your risk.

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We live in a financial world full of risks. The most common types of risks that we normally take note of are default risk, credit risk, interest rate risk, liquidity risk, third party risk etc. However, most investors tend to take foreign exchange risk for granted, perhaps because this could be an indirect risk.

Foreign exchange takes place when you or your investment deal in another foreign currency which is not your investment’s base currency, or your country’s base currency. For example, if you are buying a UK Growth Fund, which is denominated in Pound Sterling, you will automatically enter into an exchange rate risk. Why? Let us assume that you invested GBP10,000 in this UK Growth fund on the 1st of June 2016. The European Central Bank (ECB) market rate was at 0.7736. In reality, when you are going to exchange funds from one currency to another, you will be charged a ‘margin/markup’ from your exchange rate provider or bank. The amount of profit the bank will make would vary, normally depending on the amount of the transaction and the expected amount you transact in a year. For retail investors or households, this rate would not be the most exciting thing you have ever seen. On average, the rate will be ‘loaded’ by around 2%. This means that you would be paying an extra 2% ‘hidden cost’ when exchanging your funds from EUR to GBP. Taking this assumption, you would have used the rate of around 0.7580. This means that you would have been required to pay EUR13,192 to get GBP10,000 on the 1st of June 2016.

Around 5 months have passed and we are going to assume that your investment was stable and you have made no losses or profits on the value of shares/units in GBP. However, you realised that the exchange rate today is 0.8866. When you checked with your bank to exchange GBP to EUR, the bank or broker would add another 2% to your exchange rate as a ‘margin/markup’ which would cover the broker’s fees. This would provide an exchange rate of around 0.9045. Hence, if you would like to convert your GBP back to EUR at the rate of 0.9045, you would get around EUR11,055. This would have resulted in a loss of EUR2137 (or 16% on your original investment) in just 5 months based solely on the exchange rate movement.

The above was given as an example to help investors realise the extent of the risk one is taking when entering into foreign currency exposures. Such exposures can be hedged (or covered), however, these are very difficult to be managed for retail investors. The main ways to hedge an FX (Foreign Exchange) exposure are by either opening an exact opposite trade on the market, by locking in a rate on the forward market, by an FX Option or by a Swap agreement. The first two are very common especially for small businesses while the latter two are more common for those large or medium institutions which have an ongoing exposure to foreign exchange.

You may also have an exposure in foreign exchange without being aware of. For example, let us take a UK Growth Fund example again. However, this time, the UK Growth Fund is being offered to you in EUR. Therefore, you will be buying the fund in EUR and you will have no apparent FX Risk. However, when one looks deeper into the matter, one would realise that the fund itself is exposed to FX risk since the manager invests in stocks that are priced in GBP. Thus, it would be a decision of the fund manager or Board of Directors to decide how such a risk is managed. In such a case you will have an indirect FX Risk. Thus, taking the same scenario above, if the fund did not hedge the FX exposure, you would have probably seen a depreciation in the fund’s price in EUR terms. In such a case it would be strongly recommend that the investor read through the Prospectus of the fund and identify the risk management policies of the fund when it comes to FX risk management. If such a policy does not exist, then such a risk must be taken in consideration before an investment decision is made.

How and why are foreign currency rates affected?

There are three main ways of how foreign exchange rates are affected. The first and most common one is through fundamentals. This means, that if the UK economy strengthens and that of the EU weakens, then the value of the Pound would usually rise against the value of the EUR. There is also the case of ‘expectations’ vs ‘reality’. You may have a situation where, for example, you have positive news from the UK and still see the Pound lose value. The reason is that the market could have expected a ‘better’ result even though the result in itself was positive. For example, unemployment rates were published by the UK and these indicated a fall in unemployment. The news by itself is positive. However, the market was expecting the unemployment rate to be even lower than that published. In a highly liquid and transparent market such as the FX market, expectations are also factored/priced in the FX Rate before the actual result is published. Hence, when expectations differ from the real result, one would expect an adjustment in the rate accordingly.

The second way how rates are affected is through speculation.  Speculators would be taking ‘bets’ that a rate would go up or down. Such bets can be aggressive which may affect the rate itself and/or create an influence which would lead to more speculators betting in the same direction making the rate move. The forex market is a large market and in fact trades over US$5 Trillion a day! It is difficult for a single broker or speculator to make an effect on the market on its own. However, a combined effort would have its effects. There is also the issue of a ‘self-fulfilling prophecy’. If everyone thinks the rate will go down if it hits a particular rate level, then everyone would be making bets based on this expectation. This would create a self-fulfilling prophecy and the market would move accordingly. However, one should note that speculation usually affects the market in the short term and it would be fundamentals that would work in the long term.

The third way how foreign currency may be affected is through government intervention. Such intervention is very rare as it may create trust issues when it takes place or other economic effects which may not be desirable. A particular government may use monetary policy to control the value of the country’s currency. This is more easily done when the currency is of a single country. For example, it would be very difficult to see a government intervention from the EU towards the Euro as all countries would need to support such a decision. However, it would be relatively simple for the UK, for example, to impose or use such monetary policy. For instance, the Bank of England may decide to print a lot of Pounds and increase the money supply which would result in devaluation of the Pound. The Bank of England may also buy excess Euro to keep the Pound stable at a particular level. This is normally done to ensure competitiveness in the UK when compared to other markets. This was done in 2011 by the Swiss National Bank (SNB). The SNB at that time guaranteed a rate of 1.20 against the EUR by purchasing excess Euro on the market. However, in early 2015 the SNB decided to discontinue this without warning and the EUR/CHF crashed by over 20% instantly creating panic in the market. This is why government intervention is very rare and it is avoided unless there is a clear requirement from the government to step in and safeguard the country’s interests.

What does a Brexit mean for the Pound?

This is a tricky question as there are far many uncertainties on the future of Britain and how the economy is going to be effected. The market is currently reacting as follows: if the UK exits the EU, then the Pound would lose value, if not, then the Pound would gain. The main probable reason for this is due to the expected taxes that the UK would probably have to pay when dealing with the EU. This would make UK products less competitive in Euro terms when dealing with other EU products as these would be loaded by say 15% tax or so. Hence, for the UK to compete in such a market after being taxed, the GBP would need to lose value to make up for the increase in price due to taxation. However, the biggest issue of such a currency devaluation would be that as it helps exporters to maintain their competitiveness, it would make things difficult for importers as they lose purchasing power when importing goods from the EU and paying in Euro. This is because they would need to fork out more Pounds for the same amount of Euro they would have paid a few months back.

The Bottom Line

Thus, to conclude, for retail investors, ideally one should avoid FX risk. The market is very large and unless you cannot avoid such a risk, then it would probably pay if you just avoid it by sticking to your home currency when investing. For institutions, hedging such an FX risk is important. One should remember that a company is not there to make profit from FX. The importance here is managing your losses and removing uncertainty due to changes in currency valuation. This could simply be done by a forward contract or through innovative FX Options products which are available on the market.

As always this post is for information purposes only and does not constitute any form of advice – the general disclaimer should be kept in mind.

About the Author

This has been a guest post prepared by Mr. John Caruana. John holds an M.Sc in Banking and Finance (University of Malta) and has been working in the local financial services industry for the last 8 years in various roles from investment advisor to ForEx trader. He is currently the managing director, compliance and MLRO of a locally listed investment services company and sits on the Board of various funds.

Fixed Income

The Local Bond Market and the Interest Rate Game

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percent blocks

The fact that interest rates are at an all-time low, especially in the short history of the local bond market, is known to all investors. Given such a scenario, the following question are interesting to consider:

  • Are all investors factoring in the possibility that interest rates could go up?
  • Are they factoring in the situation that they could be stuck with a lower yield than what they could get on the market once interest rates did in fact go up?
  • Are they appreciating the fact that if interest rates go up the companies borrowing at the low rates might not afford to refinance their bonds at a higher rate?
  • Are the low interest rates and such high demand for any return attracting the wrong bond issuers?

The post will expand on the above questions and other related issues focusing around the local bond market, low interest rates and the high demand for interest paying investments.

The Local Government Bond Market

Following the latest movement of falling interest rates that begun in the aftermath of the 2007-09 financial crisis we have seen the local government issue bonds that are longer dated and have lower interest rates than ever before. These two factors increase the interest rate risk of holding such bonds. But with not many alternatives around the demand for Malta Government Stocks (MGSs) has been consistently strong.

Looking at the yield to maturity (YTM) on the MGSs one would see that it is less than 1% for all bonds with a maturity until 2028. Furthermore, the YTM on the MGSs beyond 2028 goes up to a maximum of just 1.88% which is for a bond maturing in 2041[1]. What this effectively means is that the Maltese government can borrow for a period of over 25 years at a cost of less than 1.9%. The major risk here is that within a period of 25 years a lot can happen, including an increase in interest rates.

Let us take a scenario where interest rates went up by 2% in 10 years’ time and use the 2.40% MGS 2041 as an example. So in 10 years’ time the maturity of the bond would be 15 years away. The current YTM on a 15 year MGS is around 1.15% when the base rate (as determined by the European Central Bank and upon which all other interest rates are calculated) is 0%. So if the base rate had to go up to 2% in 10 years’ time we can assume that the YTM on a 15 year MGS should be around 3.15% (i.e. 2% higher). For the 2.4% MGS 2041 to be yielding round 3.15% in 10 years’ time its price has to go down to around €91 per 100, which is almost 18% lower than the current price.

Of course the above is just assuming that interest rates go up by 2% in 10 years’ time, this could be argued to be a conservative approach. So what would the situation be if interest rates went up by 2% in 5 years’ time instead of 10 years’ time? The price of the 2.4% MGS 2041 would go down to around €80 per 100, representing a fall of around 27% from the current price.

Bond YTM

The Local Corporate Bond Market

Corporate bonds are bonds issued by companies, so on the local bond market it includes any bond that is not an MGS basically. In this area we have also seen a predicted move toward issues of lower interest coupons and the maturities have more or less been at a standard of 10 years. It is much less easy to compare different corporate bonds than it is to compare different MGSs. This is so since different entities will have different risk factors, while MGSs are all issued by the same government of Malta.

So not every issuer is as safe as the rest, for example an issuer who has just one project in Libya is considered much riskier than an issuer that has a diversified portfolio of assets that generate income streams from different markets. The problem is made much worse when interest rates are so low that many issuers are attracted to the market and demand is so high for any interest yield that almost every issue gets over-subscribed.

Such a scenario could create a very devastating outcome when all issuers are able to borrow at below risk-adjusted rates in the current market. The risk here is that if interest rates had to go up by the time such issues mature the company might not be able to re-finance its bond at a rate its cash flows could afford. So for example, we have the upcoming Premier Capital bond maturing which will be rolled over. In the company announcement it was stated that €24.6mln of the old bond will be exchanged for €65mln of a new bond. Assuming the usual 10 year bond maturity is chosen and considering the YTM on the currently existing corporate bonds, it is not difficult to assume that the coupon interest rate on the new bond will be below 4%. One can argue that since the coupon is so much lower the company can afford to actually borrow more (the old bond had an interest rate of 6.8%). This is all well and good, but €65mln is considerably more than €24mln so the interest expense will definitely be higher.

The point I am trying to make is the potential problem that could exist in 10 years’ time when this new bond matures. What would happen if interest rates had to go back up to what they were 10 years ago when the initial bond was issued – would the company afford to refinance such a large amount of borrowing at a higher interest rate? Would investors panic if interest rates go up by 2% in 5 years’ time and the price of the bond would fall to the lower €90s per 100?

I have used the Premier Capital bond just as an example since it is the latest issue to be coming to the market. This is not the riskiest bond issue on the market which actually makes the whole situation worse. In reality there are many other bonds that could suffer the same fate if interest rates had to go up. So what could result would be a simultaneous fall in price of local bonds. Imagine a situation of many bonds on the market falling towards the mid to lower €90s per 100 meaning that investors would be down say 7-10% from the current prices of their bonds. Would we have a situation of a rush to sell such bonds? Considering the fact that such bonds could get very illiquid very fast the prices could go well below the theoretical prices I am assuming here. To make matters worse funds and other investment vehicles that invest into the local bond market which may hold large amounts of the issued bonds could be making the whole situation even worse. If faced with a lot of redemptions at once due to the potential quick fall in the price of these funds an even worse fire-sale situation could ensue.

The Bottom Line

In conclusion it must be stated that the above is all based on assumptions that interest rates go up within the medium to long term. This can very well be the case, but we could also have a prolonged period of low interest rates. In reality it is anyone’s guess and no economic model can accurately predict the reality we will experience. The key to lower one’s risk is to stick to the safer bonds with the shortest maturities and to diversify the portfolio as much as possible. Such a scenario is not favourable to the buy-and-hold investor who would buy a bond with the intention of holding it until maturity. Thus it would make sense to take profits when prices have risen to a decent amount and crystallise such profits by actually selling the position. By doing so and reinvesting into new issues on a regular basis an investor could lower the risks I have focused on here, but they would not be eliminating them. As usual, please refer to a professional investment advisor before taking any investment decision and the usual risk warning applies that nothing presented here is actually investment advice.

 

[1] Figures are as at 21st October 2016

General, Historical Financial Events, Other

Non-Performing Loans – an EU perspective

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ecb39

The bread and butter of a traditional bank is the provision of loans. Although banks have reduced their dependency on this main source of income by branching out into other fields of the financial services world, the creation of loans is still a very important economic service. These loans are granted to households, business and to other banks, can be short or long term in nature, having a fixed, flexible or no interest rate and will be subject to different assurances such as collateral.

What is common between all loans is that they all carry a risk – the most basic of which is the risk that the loans become bad-debts or non-performing because the person or entity that took the loan can no longer service it. Non-performing loans will always be a problem for all banks since no model can ever cover all the risk involved and from time to time some borrowers will inevitably be faced with situations that were thought unlikely to happen.

From a regulatory point of view, a loan becomes a non-performing loan once more than 90 days elapse without the borrower paying the agreed instalments. Sometimes the banks can manage to agree new terms with such borrowers but at other times the bank would simply have to write off the loans and try to collect on the collateral and guarantees it would have secured before granting the loan. Banks also have the option of selling off the loans, but this will be at a discount and is dependent on finding someone to take on that debt.

What is the cost of non-performing loans?

It should be kept in mind that the cost of non-performing loans is a direct burden on the bank but an indirect burden on potential borrowers. As a bank is faced with more and more non-performing loans it would inevitably have to tighten credit and thus lend out less money. It must do this since its profits will start getting eaten away by the cost of managing the non-performing loans. Although loans are an asset for a bank they also come at a cost. The cost is not just the opportunity cost of using the same money for a different venture, but also the regulatory cost of keeping the loan on its books.

Therefore, as the number of non-performing loans rises the greater economy will suffer as loans become more expensive and less available. The expense could be in the form of higher interest rates, higher requirements for collateral and more stringent terms for the borrowers. As these factors come into play it would automatically become more difficult to obtain credit from a bank and thus some people and entities will be rejected for a loan. As credit becomes more difficult to obtain businesses will invest less and private individuals will take on less projects. So the effect on the whole economy is multiplied since less work is generated.

How do EU countries compare on Non-Performing Loans?

The below chart depicts the amount of non-performing loans as a percentage of total loans for the EU countries as at March 2016:

npl-mar2016
As expected the countries with the biggest economic problems have the highest percentage of non-performing loans. Countries like Cyprus which experienced a banking sector crises in 2012/13 and the so called PIIGS (Portugal, Ireland, Italy, Greece & Spain).

If we focus on the worst two countries (Greece and Cyprus) we can see that almost half the loans that have been issued are not being serviced. This of course is a very worrying situation for these two countries which is very difficult to get out of. These two countries are quite apart from the rest of the pack with the next worst country having a percentage of around 20%, which is still worrying. Ireland has started to improve as an economy but the percentage of non-performing loans is still quite high at around 15%. Having said that, the figure has gone down from the 20% registered in September 2015. Malta is sitting around mid-table, however it is worrying to see that over a period of 6 months the figure went up from 3.7% to 6.8%.

The below figure shows the same rates 6 months earlier as at September 2015:

npl

The Bottom Line

Non-Performing loans are an indicator of economic health. The higher the percentage of such loans to total loans the more difficult and more expensive it is to obtain loans. This has a ripple effect on the economy as less investment and private consumption is registered. This is why the regulators place great emphasis on the measurement and management of these loans. Supervisors monitor the overall level of non-performing loans across euro area banks. They also check whether individual banks adequately manage the riskiness of their loans and if they have appropriate strategies, governance structures and processes in place. This is part of the common supervisory review and evaluation process (SREP) that is carried out for each significant bank every year. Furthermore, the European Central Bank regularly carries out coordinated exercises to review the asset quality of the banks it directly supervises.

KD

Fixed Income

Are Secured Bonds Safe?!

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secured-or-unsecured-loans

On the local market we are increasingly seeing bonds being issued secured or guaranteed. In simple terms this means that the issuer has earmarked specific assets to act as collateral just in case the issuer defaults on the Bond. This is similar to the special hypothec that a bank will demand on a property (and/or other assets) when you take out a home loan. On the other hand, when we have a bond issue that has a Guarantor it normally means that a company separate from the issuer is guaranteeing to take on the debt should the issuer default. These features make such bonds more appealing to the retail market, are regarded as safer and hence may be easier to get regulatory approval for and may mean that the issuer can issue the bond at a lower coupon (interest rate) on the back of lower perceived risk. However, are all such bonds really safer?!

Although the features in themselves would make a bond issue safer than if the issue did not include the feature, one must bear in mind to consider the whole picture. Especially when comparing a bond by one issuer to another issuer. The best way to demonstrate what I mean here is to consider some real life bond issues.

A Comparison between a Secured and an Unsecured Bond

So let us consider the 3.50% BOV 2030 bond and the 4% MIDI Plc 2026 bond.

Starting with the BOV issue, being issued by a bank in order to raise its tier 2 capital the bond was issued subordinated, unsecured and including the bail-in clause. What this means is:

  • Subordinated: if BOV had to default on the bond payments the bond holders would be ranked lower than the senior debt of the bank (such as loans from other banks)
  • Unsecured: there are no specific assets acting as collateral exclusively for the bond issue
  • Bail-in clause – subject to certain conditions, should the company be in difficulty and risking a default the bonds may be converted to share and/or subject to a hair-cut (reduced in nominal value).

While the MIDI bond issue was secured by the following assets:

  • Immovable property of the Issuer comprising commercial premises (€25.5 million), car parking spaces (€19.7 million), storage rooms (€1.9 million) and properties earmarked for development (€0.6 million).
  • Pledge of 11,699,999 shares in T14 Investments Limited (C 63982), having a value of €11.7 million.

I must point out the analysis is going to focus mainly on default risk, i.e. the risk of the issuer defaulting on the bond. In order to truly appreciate all the risks with these two bond issues in question one needs to consider other risks as well such as liquidity, maturity and interest rate risk. The aim is to compare the default risk between secured and un-secured bonds of two different issuers.

The importance of considering Probability

An important factor when analysing risk is probability. In simple terms risk is all about 2 factors:

  1. the probability of an event occurring – in our analysis here the event would be a default or near default.
  2. the consequences if such an event actually occurs.

So taking BOV vs MIDI as issuers, the higher risk of default lies with MIDI. This is apparent from the balance sheets and reserves of the two companies. Furthermore, BOV operates in a highly regulated market characterised by constant supervision by local as well as foreign supervisors. MIDI operates in the real estate industry which is illiquid by its very nature. Furthermore, most of the assets owned by MIDI are concentrated in one limited area (Tigne Point), while BOV has a network of properties and a diversified portfolio to assets spread cross different industries and geographical regions. So when it comes to point 1 – the probability of the default or near default occurring is higher for MIDI than for BOV.

Now let us consider the consequences if the event had to occur and BOV was close to default. The whole idea behind the bail-in clause is so that the tax payers would not have to take on the expense of bailing out the bank like what happened in other countries during the financial crisis of 2007-09. What this means for bond holders is that they are taking on more risk and responsibility by buying into these bonds. What results should be more supervision by the bond holders themselves since they now have more at stake should the financial position of the bank deteriorate and this is something known to the management of the bank. So in a way it could act as a safety measure in the sense that the management now is subject to wider scrutiny and hence has to act more vigilantly.

If we assume that the bank comes to the point where it has to enforce the bail-in clause and converts some of the bonds into shares this would be done at a very low share and thus the bondholders would lose out quite a bit. However, there is an important factor to consider here – the loss would be an un-realised or paper loss and not a realised one. This means that should the bond holders hold on to those shares and the bail-in actually works the value of the shares would be expected to recover over the years. One must keep in mind that a bank such as BOV is a very systematic company meaning that if it had to default the repercussions on the whole economy would be tremendous and much larger than if MIDI had to default. Thus, every measure possible would be used in order to save the bank.

If we take MIDI on the other hand one might consider that the bond holders are safe since if the company had to default the assets used as security would make up for any loss in value. Unfortunately things are not that simple. If the company had to default it would mean that it did not sell and/or rent enough of its properties. This means that if it had to default the value of such properties (the security) would go down and we would have a situation where a supply side shock could be created where a significant amount of properties concentrated in the same small area would be put up for sale. Thus, considering the fire-sale prices that would exist in such a situation the security making good for the €50mln of issued bonds could very well be lower in value. Another thing to consider with the securitisation of assets is that other lenders would know about this special hypothec and thus would consider themselves in a high risk situation. So if the company needed to borrow more money in the future it would surely be more expensive for it to do so. This is an important point when considering the fact that it intends to eventually develop the Manoel Island properties.

The Bottom Line

In conclusion, it must be pointed out that the risk of default of either of the issues mentioned above is not considered to be high. I took extreme situations in order to demonstrate what would be expected if such events occurred and the secured vs unsecured attributes were tested. The point should be clear that just because a bond is secured it does not mean that it is less risky than another unsecured bond.

The fact of the matter is that the riskier issuers are the ones which in fact need to issue secured bonds in order attract more and/or cheaper finance.

I would also like to highlight once more that the analysis was simply on the default risk and other risks need to be considered before investing into these or any other investments.

KD

Fixed Income

MIDI Plc vs IHI Plc – a Bond Comparison

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MIDIvsIHI

This past week we have seen the announcement of two new bonds with similar features being issued by two different companies, namely MIDI Plc and International Hotel Investments (IHI) Plc. Both bonds will have a 4% coupon and will mature in 10 years’ time. Furthermore, both are secured, meaning both issuers have safeguarded specific assets that will be tied to the issue of the bonds.

Instead of going through the salient features in great detail I thought it would be more interesting to offer a comparison of one bond against the other. This should help investor to decide which one to opt for if they intend to invest into them.

 

4% MIDI Plc 2026

4% IHI 2026
Principal Activity “development and disposal of immovable property situated in Malta at Tigné Point, Sliema and Manoel Island, Limits of Gzira. MIDI operates principally in the high-end segment of the property market in Malta.

“In June 2000, the Company acquired land comprising Tigné Point and Manoel Island from the GOM by title of temporary emphyteusis for a period of 99 years as from 15 June 2000. Construction works commenced in late 2000. Under the same Emphyteutical Deed, the Issuer also acquired from the Malta Maritime Authority, for a period of 99 years, the right to develop and operate a yacht marina on a defined area facing the south shore of Manoel Island in Ta’Xbiex Creek, Limits of Gzira”

 “ownership, development and operation of hotels and ancillary real estate in Europe and North Africa.

To date, IHI has acquired and/or developed hotels in Prague (Czech Republic), Tripoli (Libya), Lisbon (Portugal), Budapest (Hungary), St Petersburg (Russia) and St Julian’s (Malta). NLI is a joint venture between IHI and LFICO, each party holding 50% of the issued share capital in NLI. NLI owns the 294 roomed luxury hotel and residential development in London (UK)”
Security Various properties owned by the Company plus shares in T14 Investments Ltd The Hungarian company IHI Magyarország Zrt is listed as a Guarantor.
Major Risk Factors The bond is backed by what the Company owns and the Company depends on the selling of high end properties and the leasing of commercial spaces. So if the high end market had to take a hit not only would the Company be in trouble, but even the security of the bond would lose value! The Company is suffering losses from its ownership of the hotel in Libya and the hotel in St. Petersburg due to the ongoing turmoil and political unrest plus weak currencies in these countries. This is being compensated by the positive results in the other countries, yet still in 2015 the company registered a loss. The highest risk going forward is the major project that the Company is considering for the St. George’s Bay area. So tourism and real estate are the areas that will determine the success going forward.
Risk-Reward Ratio Not worthwhile. The risk involved in definitely not worth the reward of a fixed 4% for 10 years. Having said that, the 4% level is in line with what the secondary market bonds are going for so the Company is right to issue such a low interest rate Same as for MIDI.
Reason for the Issue To pay off the maturing bonds worth around €40.8mln, paying off other obligations and general maintenance and restoration work To pay off obligations of the group in respect of outstanding debt and acquisition costs, plus a maximum of €10mln on professional fees for the St George’s Bay Development.
Chances of Allotment Quite Low unless you hold the old bonds – with €40.8mln replacing existing bonds which one would expect an acceptance level of 80-90% and €2mln earmarked for the shareholders of the Company there is not expected to be much left for the general public. Medium – One would expect high demand for the bonds given the lack of available options. €30mln is earmarked for shareholders, even if this is fully taken up by existing shareholders there are still €25mln left for the general public.
Treatment of Existing Bondholders Unfair. Part of the existing bonds being replaced are denominated in GBP. The conversion rate for the GBP bonds (since the new ones will be issued solely in EUR) was established after the Brexit at €1:£0.834, so the GBP bondholders got a rotten deal on the exchange. On top of that existing holders who used to earn 7% will not be earning 7% until December which is the actual maturity date of the existing bonds. If existing bond holders invest into the new bond they will start earning 4% from when it is issued and forgo the difference in rates until December. Much Better! In the past whenever IHI or Corinthia have rolled over existing bonds they always paid the full interest until the maturity date of the bond, even when they rolled over for a lower amount. In such cases the company would have paid the difference in the two rates so that the investor is not left worse off for investing into the company again.
Would I Buy and Hold? NO. At 4% fixed for 10 years and given the risk involved I would not expect this to be a great addition to a portfolio to keep until maturity. To keep short term and earn the 4% interest until something better comes alone, ok. But if the price goes up enough, I would definitely sell out and take the profits. Same as for MIDI.
Expected Demand High. The fact of the matter is that there are not many alternatives and investors have accepted a higher risk tolerance for lower returns (even if they have not realised it yet). Same as for MIDI.

 

The Bottom Line

Comparing the two issues one has to keep in mind that with neither is one getting a good deal here. Having said that they are offering what one could find on the market with other existing bonds which are yielding between 3.5%-4% for similar risk bonds. When deciding between the two one has to keep in mind the chances of being allotted a decent amount for the amount applied. My notes in the above table should be kept in mind, the clear winner would be the IHI bond on this point.

A worrying point in my opinion is the treatment given to these issued by the listing authority which actually shapes the terms and conditions under which the bonds may be sold. Towards the end of 2015 and beginning of this year we had the complex BOV bond issues which were very restricted in to whom they could be sold. A few months ago we had the GlobalCapital roll over which was also very restrictive in o whom it could be sold. Now we have these two issues which are open to anyone. This begs the questions:

  • Is MIDI really that much safer than GlobalCapital?
  • Are MIDI or IHI safer than BOV as an issuer? – definitely not!
  • Is the security being put forward that safe?
  • How will the assets of both MIDI and IHI be affected by the Brexit and the concerns in the EU?
  • How big of a concern is the exposure to Libya for IHI – both directly and through its strategic partners the Libyan Foreign Investment Company (LAFICO) and its ownership though MIH Plc?

As usual, before investing into any of the mentioned financial instruments please consult the prospectuses and a good financial adviser. Kindly note the usual general disclaimer that applies to all my publications.

KD

General, Historical Financial Events

Brexit – Making Britain Great Again

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brexit-shutterstock2

 

The more I read into the arguments put forward by the leave campaign who are rejoicing over the “win” that they have just accomplished the more I compare them to the businessman running for the US presidency. Trump’s motto “lets make America great again” seems to have been copied by the leave campaigners who have a motto “lets make Britain great again”. What a role model to choose!

They propose to do so by having more control over their laws and to decide better on how to spend their money. This sort of “centre of world” and “us versus them” mentality seems to be coming from the disillusion of the older generation of the Brits who still dream of the glory days of the British Empire. In actual fact no state is ever totally independent nowadays since they all depend on one another to one extent or another. The more trading partners a state has, the more its economy will grow and the more its people will prosper. Whether the UK admits it or not it needs to trade with Europe as much as Europe needs to trade with the UK.

So ultimately the British will need to negotiate trade agreements that will most likely be as similar as possible to the current agreements in place. The main difference will be that it will cost the UK a lot of money to renegotiate everything. It seems like all of the world understood this concept except the older generation of the Brits who are still disillusioned by the British Empire mentality. Time will tell if it was a good move or not, what is clear is that the students and young generation who will have to deal with it all definitely did not agree that it would be better to be out.

The Financial Sector and Passporting Rights

The financial sector would definitely be one of the hardest hit sectors as a result of the Brexit. We saw this clearly with prices of the banking stocks around the world taking such a big hit on Friday 24th, the day the results were announced. London is a very important financial hub that is a gateway for many non-EU countries. A big advantage that the EU offers in the financial services sector is the right to passport a license. What this means is that an entity that is regulated in the UK can very easily acquire Passporting rights to operate in the other EU jurisdictions without needing to acquire full licensing in each member state. So for example, if Morgan Stanley has a fund licensed in the UK it can easily and cheaply get permission to promote and sell it in the other jurisdictions with the blessing of each jurisdictions’ regulator.

Since the UK has just voted to leave the EU the passporting right no longer applies to UK regulated entities and products. Thus sticking to our example, Morgan Stanley would have to go to another member state and get its product fully licensed there and then can passport it to the other states. What this means – London just became much less attractive to use as a hub and other jurisdictions will benefit from this.

The people who voted to leave the EU, who were mainly the older generation and people from the North might be thinking, we don’t care about the bankers and high earners working in London. Serves them right to lose their jobs after all we have done to bail them out in the crisis. This of course is the one of the most idiotic arguments one can make and again we see a likeness of the mentality of the leave campaign to Donald Trump. In simple terms: banking sector does bad = whole economy does bad = fall in purchasing power. Who will pay for this all? The tax payer as usual. So the hard working Brits (who either voted to leave the EU or who applied a little logic and voted to stay in) will pay the price for it all.

Who will gain most from Brexit?

First we have the politicians who have used the Brexit to their advantage. People like Nigel Farage and Boris Johnson who I am sure made a bucket load of money from all this and have gained more support that will see them advance in their political career. Then we have the consultancy firms who will be in high demand by both the private sector and the government entities themselves to see how the Brexit will actually affect them. Finally we have China. With a weaker union and a smaller EU block China gains in the long term by attracting more trade towards its jurisdiction and away from Europe. So congratulations to the Brits who voted to exit Europe – you have just made the politicians, lawyers, accountants, other consultants and the Chinese very happy indeed.

The Bottom Line

Ultimately billions of pounds will be spent in relation to the transition to the free “independent” UK. So most of the gains that the Brits thought they would save by not being an EU member would still be spent on new negotiations and added costs of trading. Animosity is clearly present within “great” Britain with speculation that Northern Ireland and Scotland might seek independence in order to remain in the EU. We even have petitioning for London to be declared a separate state and also remind in the EU. I will close the post on a light note however. In one of the interviews with Nigel Farage after the Brexit result in which he admitted that he had twisted words about NHS funding he also stated that Britain should consider more trade with the Commonwealth. Please check out this humorous clip in relation to the notion of the Commonwealth and “great” Britain: https://vimeo.com/131934966

Legal, Other

MLRO: Friend or Foe?

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Money Laundering

A Money Laundering Reporting Officer (MLRO) is responsible to ensure that the company they work for is compliant on aspects of Anti Money Laundering (AML) and Countering the Financing of Terrorism (CFT). Having just attended a 2 day seminar on AML, which for a change was not a total waste of time, I was inspired to write a post on the position of an MLRO. A person occupying this role can be considered as both a great friend and a great enemy by their colleagues.

Friend

The friend part comes from the point of view that a good MLRO will ensure that the business is abiding by the AML laws and regulations. Besides meaning that the entity would be compliant, it also means that the business is not taking on any unnecessary business risks. An effective MLRO would have in place robust systems and procedures to ensure the entity they are working with is covered from all angles. This involves detailed written procedures that everyone in the organisation is made well aware of. It is useless to have the best system possible for your particular business but then the people who have client contact are not made aware of the system. Thus, regular and effective internal training is necessary in order for the MLRO to explain to the people working in the organisation about their duties and responsibilities from an AML point of view.

In order to have an effective system the MLRO has to be approachable and people have to be made aware of who the MLRO actually is. Although the MLRO must be a senior officer within the company, they cannot be just sitting in a head office with nobody on the ground floor knowing who they are. Also, simply sending an email with the company’s AML manual or giving an employee a copy of such manual is not enough. Most people would simply ignore it or read it once and just dismiss it. So the MLRO must find a way to get people interested in the work they do and get them to understand its importance.

An easy way to do this is to simply explain how an AML breach could be detrimental to the person’s job and the whole organisation’s existence. The fine that the entity might receive if it is in breach of AML rules and regulations is just one aspect – the reputational risk of the entity could perhaps be the largest risk factor. So if colleagues see their MLRO as the one who helps them stay in check and avoid costly risks they will see them as a friend.

Foe

Of course, like with anything to do with compliance it is much more common to look at the MLRO as the enemy. From the point of view of directors and shareholders the MLRO, like the Compliance Officer could easily be regarded as being an extra expense that causes more expenses and disruption of potential business. While senior management might want to take on a risky client and try to justify the risk-reward trade off of doing so, the MLRO would be the person to highlight the risk part and perhaps seen as exaggerating this aspect.

From the point of view of the people who are actually in contact with clients the MLRO could be the one that would bar them from pursuing certain potentially lucrative client accounts. They could also look at the MLRO as the person who is forcing them to get a stack of useless paperwork on a client that they have known for years that could cause the business to lose such a client.

To be fair certain MLROs do not make it easy on themselves and tend to be too strict and annoying in their pursuit of carrying out their duties. Just because an MLRO needs to be sure that absolutely everyone is covering all aspects of the AML rules it does not mean that they should be policing their colleagues in an antagonising and perverse manner. If people see their MLRO as the enemy the system will not work effectively and mistakes and oversights would be inevitable.

Furthermore, if an MLRO is over-reaching and going over and above the requirements then they would definitely be seen as the enemy. Over stepping and being extra safe is also bad for business. No profits can be made without certain risks and if an MLRO is holding back business due to over-reaching and trying to be holier than the Pope, then it will ultimately back fire through loss of good business. I am a great opponent of over-regulation, which can be either brought upon by regulators or by the people who are in charge of enforcing the regulation within organisations.

Finding a Balance

The key is to finding a balance. Unfortunately being seen as an enemy and a necessary evil that comes with the job. The MLRO must recognise that it is not his/her responsibility to decide what degree of risk a company would like to take. That decision remains always at the discretion of the directors who are responsible for the overall direction of the business. However it is the MLROs job to notify top management about the risks involved from an AML perspective and to work with them to develop the best working environment.

A very interesting exercise that was undertaken during the seminar I recently attended was to divide participants into groups and work on a case study. The case study involved coming up with a scheme on how to launder €150Mln for a multi-national consortium. The beauty of the exercise was that it put people who are responsible for counteracting money laundering on the other side of the situation. The game helps one appreciate the level of complexity that is needed and the mind frame that launderers would be in. It ultimately will help in finding loopholes in the system of the company that each participant works in. So the exercise helps people learn by putting themselves in their counterparty’s situation. I believe this is an interesting and effective method that an MLRO could use in getting the AML message across to people.

Does the Regulator play a Role?

The Malta Financial Services Authority (MFSA) and the Financial Intelligence Analysis Unit (FIAU) are the regulators that authorise and monitor the work of MLROs. Do they have a role to play in the effectiveness of the work of the MLRO? The simple answer is yes, but one must not end up “depending” on the regulator to do something. Although there is a requirement for the MLRO to present an annual report to the FIAU which also includes training received and conducted there is no specification of what is actually required. So in November and December it is a common practice to see many AML “training” programs which would suffice for the purposes of filling in the MLRO training requirements.

Of course one can argue that from year to year they would still remember the laws and regulations and if there are new ones they can easily read up on them on their own. With this I agree 100% and find the “training” courses that simply go through the legislation as utterly boring and useless. In my view, it would make much more sense if the training required involved something more. Something with practical examples, case studies and something that is more interesting than watching paint dry on a humid day! It would make sense to use practical examples that have actually happened locally and training has to be targeted depending on the type of business. An MLRO of a bank has a totally different situation compared to an MLRO of an investment service company or and MLRO of a real estate agency. So having group training sessions is definitely not the ideal setting.

The Bottom Line

Whether we like them or not the MLROs do play an important role in the organisation. There is no secret formula that works for every organisation, but each MLRO has to adopt a risk-based approach to cover the issues that affect their organisation. Undoubtedly the MLRO needs to understand their organisation very well and they need to identify the weaknesses that exist from an AML perspective. However this is not enough, any system and procedures they develop are only as good as far as how they are implemented. Thus, MLROs need to find a way to monitor and incentivise the people with client dealings and transaction processing so that they actually implement the AML measures.

KD

 

 

 

 

Alternative Investment, Equities, Fixed Income, General

Retirement Planning – a Portfolio Approach

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saving_and_retirement

Retirement Planning – a Portfolio Approach

I would like to start this post by pointing out a very important fact: Planning for retirement does not mean buying an investment called “Pension Fund” or “Retirement Fund”. Many seem to think that in order to plan for their retirement they need to buy an investment that somehow has “retirement plan” of “pension plan” in its name. This is definitely not the case. In order to plan for one’s retirement one must think of all their assets as forming part of one overall portfolio.

The principal aim of retirement planning is to have a decent income once one retires from their employment and for estate planning. It is no secret that the state aid will not be enough for many people to earn an income in retirement that is compatible with the standard of living that they would have become accustomed to during their working life. Thus, it is important to plan in order to earn supplementary income. Does this mean that everyone should start buying income paying products from a young age – NO!

The best way to plan for retirement planning is for one to structure his/her assets in an overall portfolio structure. As with any portfolio investment one needs to plan according to one’s:

  • investment objective,
  • risk tolerance
  • financial affordability
  • knowledge and experience.

It must also be kept in mind that all the above points will evolve over time and are not static. Thus your retirement portfolio must also evolve to reflect these changes.

Investment Objective

For someone who is in their initial years of their working life their investment object is going to be quite different than for one who is close to the final years of their working life. Furthermore, it is not only an age thing, but other factors also have an effect on the investment objective. An initial objective of any investor would be protection. So a wise choice would be to acquire some form of life insurance and if affordable some form of disability insurance.

Let us assume we have an investor who has purchased their first home, has some form of insurance in place and a decent cash balance for regular expense items. Such a person would have a long term investment horizon and their investment objective would normally be to increase their overall capital. Thus, such an investor would be better off investing in products that focus on capital growth rather than income. The growth in capital possible through equity investing rather than investing in bonds is exponential. Therefore, it would not be wise to invest totally into income paying bonds when one has 30 odd years left until retirement.

On the other hand, someone who is nearing their retirement age should start shifting their portfolio more towards income paying investments. For such a person it would be more important to have something extra coming in rather than possibly doubling their capital in 10 years’ time. So the investment objective is going to have an effect on what investments one should have in their overall portfolio. Moreover, although income is important and normally is the main concern of many investors, if one would also like to leave something extra for their heirs then they should also consider this in their overall portfolio.

Risk Tolerance

This is something very specific to the investor. As a general rule most people are risk averse, meaning that they would rather avoid rather than increase risk. However there is the risk reward trade-off to consider which basically means that the lower the risk the lower the potential return. In general, one who is still a number of years away from retirement would tend to be more able to take on risk for the potential of higher returns compared to someone who is closer to retirement. Even psychologically, investors would be more willing to take on risk when they are younger than when they are older. However, every investor is different in the degree of risk that they are comfortable in taking on. This will affect the type of individual investments that one would put into their overall portfolio. So although a younger person might want to invest in equities to increase their capital in the long term they can buy conservative equities/equity like investments such as an ETF that tracks the overall market, or they could buy a more speculative product that for example moves 3 times the price of oil.

Financial Affordability

Like with anything else in life we should only buy investments that we can afford. The affordability factor should be considered in two main ways. The first is that certain products have a high initial cost. So for example, certain bonds trade in multiples of €100,000 meaning that one needs to buy a minimum of €100,000 in order to buy the bond. The second factor connected to affordability is the percentage of the overall portfolio that the investment will make up. What I am referring to here is the fact that although the investor might afford to buy the asset, he/she would be left too exposed to the one asset if they do in fact invest in it.

An easy way to see how this second factor could be detrimental to a portfolio is to consider investing into property. With interest rates very low and the local rental market doing well we are seeing many people investing into property with a buy-to-let setup. Let us take a hypothetical situation where we have an investor who owns their main residence which is worth around €250,000 at current market rates, has a portfolio of €50,000 in investments, has €10,000 in the bank and is now considering buying an apartment costing say €100,000 in order to rent it out. Without going into the debt factor that this will have, let us assume that the €10,000 will remain on his bank account to cater for unforeseen expenses and act as a buffer. The €50,000 will all be used to purchase the property and the balance will be borrowed from the bank. If this is the case, the assets that make up this persons’ overall portfolio would be €350,000 in property and €10,000 in cash. This would mean that over 97% of this person’s portfolio would be invested into two properties, less than 3% would be in liquid, easily accessible cash and no other investments. Through such an example it is easy to see the concentration risk of going down such a route.

Knowledge & Experience

Another important factor to consider when deciding on which assets to put into one’s overall portfolio is to invest in assets which they are familiar with. This does not mean that one should invest only in things which they have already invested into and not consider anything else. However, one should research investments which they are considering investing into before they actually financially commit themselves. There are many good investment advisors around that can help here, but supplementary research is always a plus. By searching a bit online one will find many avenues where good information can be attained on the assets they are considering investing into. So just like one would consult websites such as booking.com and trip advisor when booking a hotel, investors should also do some supplementary reading before investing their money.

Piggybank and calculator. Isolated on white background
Attaining a Decent Income after Retirement

For many the main goal when it comes to their retirement planning is to secure a decent return after they stop or reduce their main work activity. In my view this is best attained by slowly building a portfolio of diversified assets over the years. The accumulation of income paying products should evolve over time and one is not expected to invest all their money in capital growth products and switch all their money into income paying products on the day they retire. The ideal situation would be to have income coming from different sources so if one of the sources is negatively affected in some way one would have alternatives that they could depend on. So by having some income coming from rental income, some coming from direct bonds and bond funds and some coming from income paying equities one would have different streams of income which are affected by different things.

As one is building their portfolio over the years they should not forget to think of alternative investments to the regular bonds, shares and property mix. Such alternatives would include investing into commodities such as precious metals and oil, investing into art and collectables and also investing into private businesses. A good source where one could attain a good capital appreciation and even income through dividends is by investing into private companies. Many start-ups end up needing additional finance while many other well established businesses also would need extra financing for new projects or to get through a rough patch. It is true that the risk could be lager here than investing into regulated and quoted companies, but if one does their research well and finds a good opportunity they can attain an equity stake in a good company at a decent price which would pay-off in the future. Such an investment could offer good income opportunities and a good asset for the heirs of the person who would eventually take over these shares.

The Bottom Line

The main message I would like to convey through this post is that there is no fixed formula to use when it comes to retirement planning. Everyone has to assess their own characteristics and find the best mix of products that suits them. So called retirement plans are a good start but they are not an end in themselves. Some of these retirement plans do give you a tax break if you use them, but the amount of tax saved per year on them is ridiculously low to have any significant weight.

KD