09 July 2013 / by Oliver Roylance-Smith
The combination of historically low savings rates and the bleak outlook for interest rates in the coming years is leading many to consider moving some of their savings into areas with the potential for higher returns. Investing is perhaps the most obvious choice however there is a rapidly growing middle ground, which combines the potential upside of stock market linked returns but without risking your capital – the structured deposit.
Many savers are using money that historically would have been put into a fixed rate bond and so we take a deeper look at the rise in popularity of the structured deposit by comparing it with the more traditional fixed rate.
Fixed rates fail to hit the mark
We are all aware that past performance is no guide to future performance when it comes to reviewing a particular investment or how a stock market index has performed previously, but what are the main risks associated today with cash and savings rates?
In years past it would have been commonplace for savings accounts to offer inflation beating returns, especially if you were prepared to tie yourself in for the medium term. But today the difference in annual interest offered between leading instant access and five year fixed rates is well under 1% and with nothing currently offering above 3%, this is a significant change in the savings landscape. If inflation continues at its current level of 2.7%*, a basic rate tax payer needs to achieve 3.375% and a higher rate taxpayer 4.5% just to keep pace.
Risk warning for savers
Perhaps the warning that should be made by every provider before a customer buys a fixed rate bond is to make it quite clear that they will lose money in real terms unless inflation falls sharply and remains lower than its current level. If you have not yet done so, ask yourself the likelihood of this happening? The impact of inflation, especially over time, is something which not enough savers put sufficiently high on their priority list prior to taking action.
This sets the scene for the rise in popularity of an alternative to fixed rates bonds – the structured deposit. This product similarly provides full capital protection and can also be used for Cash ISA money, both new Cash ISAs and Cash ISA transfers, therefore placing it in the savings space as a potentially viable alternative to more traditional offerings.
Savings or investment?
There are a variety of structured deposits being offered in the market today. Although they can be considered as an alternative to fixed rate bonds, they also have characteristics that are similar to investments. The purpose of this guide is to help you understand what structured deposits are and what you should look out for before putting your hard earned money in such products.
What is a structured deposit?
A structured deposit is essentially a combination of a deposit and an investment product, where the return is dependent on the performance of an underlying investment. The underlying investment is normally either an Index, such as the FTSE 100 Index, or a smaller number of shares from within the Index.
UK structured deposits naturally lean towards the FTSE 100 Index as this is the most commonly quoted benchmark of investment performance and is the most familiar to investors in this country. If the deposit uses a smaller number of shares rather than the Index itself then these are normally shares listed within the FSTE 100 Index and often it is the larger shares available that are used.
How do structured deposits compare with fixed rate bonds?
Structured deposits have a few important characteristics that distinguish them from the more traditional savings accounts. With a fixed rate bond the returns and maturity periods are fixed while structured deposits on the other hand have variable returns, and in some cases, variable maturities as well.
Variable returns
Structured deposits generally provide the possibility of higher returns compared to fixed rate bonds. This has particularly been the case recently with continuing record low interest rates and historically low savings rates. However, you should balance this possibility of higher returns against the risk of variable returns. In some scenarios, you may get lower or no returns at all.
Fixed or variable maturities
Most structured deposits have fixed terms which are normally between three and six years in duration. This means you should make sure that you have enough money for emergencies during that time since you may not be able to use your money for other purposes before maturity without incurring loss to your initial capital and/or returns.
Some structured deposits incorporate the ability for the deposit to be redeemed before the maturity date. A popular example of this is an autocall, more commonly known as a ‘kick out’ plan. Here, the plan will mature early or ‘kick out’ provided the underlying investment performs in a particular way, which will be known prior to investing since it will specified in the terms and conditions of the plan. The Investec Kick Out Deposit Plan for example will mature early if the value of the FTSE 100 Index at the end of years 2, 3, 4 or 5 is higher (subject to averaging) than its value at the start of plan. If it is not on any of these dates, the plan will continue.
Early maturity
Where a structured deposit is designed in this way and early maturity does occur, you can expect to receive, as a minimum, the full value of your initial deposit. Depending on the circumstances, this early redemption feature may benefit you – for example, if you wish to use your money in other ways, you can get back your initial capital and any stated additional returns as soon as redemption occurs.
You may, however, be exposed to reinvestment risk. This is the risk of having to invest your money in a low interest rate environment when interest rates fall. To counter this, there is normally the facility to reinvest either in the provider’s current version of your original plan, or if the exact plan is no longer available, a similar plan with your original provider or another in the market. Therefore, depending on market conditions and your specific income or growth needs, a structured deposit may or may not be a good investment to put your money in.
What happens if I need to withdraw my deposit before the maturity date?
Structured deposits, like fixed rate bonds, are meant to be held for the full term. Your initial deposit will be repaid in full only at maturity. If you withdraw your deposit before the maturity date, you may lose part of your return and/or your initial capital. The amount payable to you depends on the market value of the underlying investment that your structured deposit is linked to, which cannot be pre-determined. There is also therefore the possibility that the value could be higher than your original deposit.
You should also bear in mind that structured deposits may be subject to periodic valuations which may not be on a daily basis. This means that you may not be able to withdraw your deposit immediately.
What should I consider before investing in a structured deposit?
Structured deposits come in different forms. You should consider whether a structured deposit fits with your financial goals, attitude to risk and your personal situation. When choosing a structured deposit, these are some of the factors to consider:
Liquidity
When might you need this money and do you have any additional funds available? Consider your liquidity needs as your money will be tied up for a period of time and early withdrawal may result in loss of part of your return and/or your initial deposit. Fixed rate bonds are also likely to have penalties for cashing in before the end of the fixed term which is normally linked to a period of interest (for example, six months). This amount could be higher or lower than the loss for early withdrawal from a structured deposit.
As with any fixed term plan, it is therefore prudent to make sure that you have sufficient savings set aside before investing in structured deposits.
Risks
Determine whether you have the risk appetite for these products. Structured deposits are riskier than normal fixed deposits as there is a risk that the underlying investment does not perform in the manner required in which case you may not receive any returns at all. In this scenario you would have been better off with a fixed rate bond. You should understand the risks involved and what will happen in a worst-case scenario and if you are unsure, seek financial advice from a professional.
Currently, the major risk to consider for fixed rate bonds is that your money loses value in real terms should it fail to keep up with inflation. Therefore, although you have the peace of mind of a guaranteed return, this is not guaranteed to keep up with increases in the cost of living and so your initial deposit plus any interest could in the future be worth less in real terms.
Return
Since the returns from structured deposits are dependent on the performance of an underlying investment such as stock market indices or shares, you should understand how the performance of the investment affects the return on your deposit. Remember that past performance is not necessarily indicative of future performance.
Terms and Conditions
Read the terms and conditions and other documentation of the structured deposit carefully before making any commitment. If you do not understand how the product works, seek clarification. Do not buy anything you do not understand.
Structured deposits compared to fixed rate bonds
This table compares the main features of structured deposits and fixed rate bonds:
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Features
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Structured Deposits
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Fixed rate bonds
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Minimum deposit
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Structured deposits sometimes require a higher minimum investment amount (usually £3,000) but there are some providers who offer lower minimums of £500.
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The minimum amount for a fixed deposit can be as low as £1,000 but note the recent trend for providers to offer tiered interest rates where the higher headline rates are only on offer for larger lump sums.
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Fixed terms
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Structured deposits have maturity periods that vary from 3 years to 6 years.
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Fixed rate bonds normally have maturities ranging from 9 months to 5 years although there are some who offer shorter terms.
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Early maturity
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Some structured deposits incorporate the potential to mature early each year, from as early as year 1 onwards. In this situation, you will normally receive a return of your initial deposit along with any stated returns.
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Fixed rate bonds do not normally have the ability to mature early.
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Initial deposit
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Your initial deposit will be repaid in full: (i) At maturity; or |
Your initial deposit will be repaid in full at maturity.
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Early withdrawal by the depositor
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If you withdraw your deposit before the maturity date, you may lose part of your return and/or initial deposit. The amount that you will be paid depends on the market value of the underlying financial instrument that your structured deposit is tied to, which cannot be pre-determined. You should also bear in mind that structured deposits may be subject to periodic valuation, which may not be on a daily basis. This means that you may not be able to withdraw your deposit immediately. Check the terms and conditions for early withdrawal of the deposit with your bank. |
If you withdraw your fixed deposit before maturity, the bank may levy certain charges. In most cases, your bank would have taken a corresponding commitment on your deposit with a counterparty.
When you withdraw your deposit early, your bank may have to levy charges to cover the cost of its own commitment. Check the terms and conditions for early withdrawal of the deposit with your bank.
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Risks involved
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Structured deposits are generally less risky than investing directly in the underlying investment since the bank is obliged to repay the principal in full at maturity or when it redeems the deposit before the maturity date.
However, they are riskier than traditional deposits because their returns are dependent on the performance of other underlying investment. In some scenarios, you may get no returns at all and only get back your initial deposit. Where a structured deposit is callable, you may be exposed to reinvestment risk. This is the risk of having to invest your money in a low interest rate environment when interest rates fall. Structured deposits have maturity periods that vary from 3 to 6 years and are designed to be held for the full term which means that you may not be able to use your money for other purposes before maturity, for example, investing your funds in a fixed rate bond or an alternative savings plan offering higher interest rates when interest rates rise. Structured deposits are also exposed to the credit risk of the deposit-taking institution (for example, a bank). This is the risk that the deposit-taker will be unable to fulfill its obligation to pay you even your initial deposit should it fail and become insolvent. However, in this situation it is likely that you would be eligible to claim under the Financial Services Compensation Scheme, depending on your individual circumstances. |
Fixed rate bonds are considered low-risk as the interest payable is known at the outset and your initial deposit is fully capital protected. Fixed rate bonds are similarly exposed to the credit risk of the deposit-taking institution being unable to fulfill its obligation to pay you the deposited sum. However, in this situation it is likely that you would eligible to claim under the Financial Service Compensation Scheme. The impact inflation can have on your overall return is an important risk to be aware of since if the rate of return you commit to is lower or become lower than inflation during the fixed term, the purchasing power of your capital will be eroded and you may be unable to surrender without incurring penalties.
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Financial Services Compensation Scheme
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Structured deposits are covered by the Financial Services Compensation Scheme which covers deposit claims up to a maximum of £85,000 per person, per institution, subject to your individual circumstances.
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Fixed rate bonds are also covered by the Financial Services Compensation Scheme up to £85,000 per person, per institution.
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Returns
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Structured deposits generally offer the possibility of higher returns compared to fixed rate bonds of similar duration. This is in line with the higher risks you have to bear since the return on a structured deposit is dependent on the performance of the underlying investment (such as stock market indices or shares) to which it is linked – if this does not perform as required, you may not get a return.
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Returns on fixed rate bonds are typically lower as they are less risky than structured deposits. This is because the deposit is fully capital protected and the rate of interest paid is fixed at outset and guaranteed to be paid provided you do not withdraw your money early and the provider does not become insolvent.
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The final analysis
Fixed rate bonds pay a fixed rate of interest at predetermined times throughout the fixed term, so you know exactly what you will receive and when you will receive it, giving you certainty of interest and the peace of mind which this entails. Unfortunately times have changed. One of the main reasons for the increase in popularity of structured deposits has been the over-reliance of fixed rate bonds by savers who are now seeing the real value of their savings eroded at a time when they need it most.
Structured products combine capital protection with the potential to receive higher rates than available from fixed rate bonds, and to even beat inflation. Since there is the potential to achieve only a return of initial capital, structured deposits are not however designed to meet the needs of every saver nor, perhaps, to receive your entire savings. Ultimately, which option or blend of options will depend entirely on your individual circumstances.
Weighing up all of the options
These are difficult times to say the least and it is the saver who is enduring the harsh reality of this more than anyone. Above target inflation, record low savings rates, low wage increases and an uncertain future are all relevant factors when deciding what action to take.
Understanding the impact of low rates, especially over time, and giving full consideration to all of the options available, particularly using your Cash-ISA allowances, are all good reasons to compare traditional savings accounts with alternatives such as structured deposits.
There is a wide variety of structured deposits being offered in the market and as market conditions allow, these are constantly being updated with new versions of previous issues as well as completely new plans. We at Fair Investment Company aim to provide you with a continuous selection of the best the market has to offer so keep coming back to visit us.
Click here to compare alternatives to fixed rate bonds »
* Consumer Price Index, May 2013
No news, feature article or comment should be seen as a personal recommendation to invest. Prior to making any decision to invest, you should ensure that you are familiar with the risks associated with a particular plan. If you are at all unsure of the suitability of a particular product, both in respect of its objectives and its risk profile, you should seek independent financial advice.
Some of the plans referred to in this article are structured deposit plans that are capital protected. There is a risk that the company backing the plan or any company associated with the plan may be unable to repay your initial investment and any returns stated. In this event you may be entitled to compensation from the Financial Services Compensation Scheme (FSCS), depending on your individual circumstances. In addition, you may not get back the full amount of your initial investment if the plan is not held for the full term. The past performance of the FTSE 100 Index and any of it shares is not a guide to its future performance.
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