Always read the fine print.
That’s what I thought when I saw an ad for a ‘savings’ product recently.
“1% on your savings. Are you kidding?” it asked. This product could offer you 3%, not the meagre 1% so many boring old banks offer.
I also noted the branding of this product – it’s very feminine, and targeted squarely at the ladeeeez. I sent it to my friend with the comment: ‘In this week’s episode of Pointlessly Gendered, we now have saving’.
Except this is not a savings account – well, not as we know it. It’s NOT money in the bank, covered by the Government’s bank deposit guarantee, which protects savings up to $250K (if a bank goes under).
This product pays more interest than a bank account because it’s riskier than one. It is, in fact, a debt fund. A bond fund, to be precise.
Variously known as credit funds, debt funds or bond funds, depending on the type of debt and the risk level, these are investment funds – but they are not ‘savings’ funds in the same manner of a bank account.
Credit funds are part of an established and successful asset class – they sit under the broad label of ‘fixed income’.
La Trobe Financial is one of the biggest and most reputable providers, while Mayfair 101 is one of the dodgiest (according to ASIC and the Financial Review). In fact, Mayfair 101 is in hot water with the regulators because it has frozen millions of investors’ dollars, and there’s a real chance they could lose some or all of it.
And I’m definitely not here to say credit funds are bad, because they’re not. There are some very good products: they can be a great diversifier and an effective income booster. They can also be reasonably secure.
The key is to know exactly what you’re buying when you invest in one.
And to understand that it is not the same as a bank account or term deposit.
What is a credit fund?
When you put money in the bank, they literally just hold it there for you. Yes, they make loans to individuals and companies based on the amount that people have deposited, but it’s held in a separate bucket and treated differently.
They can make home and business loans on the strength of our deposits, but our cash stays safe and sound in another part of the bank.
And if the world turns upside down and the bank goes under, the Australian Government is there to pick up the bill and return your money to you. It’s very safe, but it also means you get a low interest rate (because low risk = low return).
In a credit fund, you are part of the lending process. Your money is lent out to individuals and companies, and the credit fund manager is the intermediary. You get a regular interest (coupon) payment, at an agreed rate, and this is what generates most of the returns you receive.
But this means you are also taking on the risk that the borrower (or fund manager) will not pay you this interest on time, or at all. You also run the risk that the borrower collapses – along with the money you lent them.
Now that all sounds quite dramatic, but usually it’s not. First of all, the loans are generally to multiple borrowers, so the risk is spread across them. Depending on the type of credit fund, it might lend money to thousands of individual borrowers (for home or business loans); it might lend to hundreds of businesses; or it might be to a handful of big companies for things like property development.
What ‘secured’ actually means
Another protection is when the lender takes security over some of the borrower’s assets in order to protect their investment – this is known as a ‘secured loan’. When you get a home loan, for example, the bank takes a mortgage over your property; if you don’t repay the loan, the bank can take the house.
Similarly, a credit fund might take security over a company’s assets like warehouses and stock, or a developer’s building site. This means that in the event of a loan default, the lender could sell these assets to recoup some or all of their money.
Here’s the important point: ‘secured’ is a technical finance term that means some type of ‘security’ has been provided. It does not mean the investment is secure. You know, secure like ‘money in the bank kind’ of secure.
This detail is really important, especially for novice investors. Someone I know lost tens of thousands of dollars following the GFC, because the ‘secured’ credit investment she made was not so secure after all. When we discussed it afterwards, she really hung onto that word – but in this case it just means you have more chance of getting your money back than other creditors.
The upsides of debt investments
Just like there are many different types of equity funds you can invest in, there are many credit or debt funds with different characteristics. One of the advantages of having professional investment managers is that they can invest in lots of different loans and spread the risk across them. It means that some of them are, in fact, on the lower end of the risk spectrum compared to equities, for example.
The other benefit of investing in debt is the potential for ‘capital preservation’ through two mechanisms:
- The loan amount getting repaid – if everything goes to plan, the borrower gives back the money at the end of the loan term (which is usually deployed into new loans at that point).
- The lender can take possession of secured assets – if the borrower gets into trouble, the lender can take any assets that have been secured, sell them, and get some of their money back.
This is an important point when comparing debt investments to equity investments (i.e. shares). Lenders are generally ahead of shareholders when the shit hits the fan. In the event of a business going belly-up, creditors have more rights to the leftover assets than shareholders, who can be – and usually are – left with nothing when a company collapses.
The other benefit of credit funds is that the income is usually more predictable. The borrowers have agreed to make regular payments (just like your home loan), which the fund is obliged to pass on to investors (after fees of course).
With equities, dividends are only paid if the company makes a profit, and even then, it’s totally up to management to decide whether they pay a dividend – and how much.
Unlike share investments, however, debt funds don’t see any capital growth. That’s where they are similar to bank accounts – whatever you put in is what you get out, beyond the interest paid.
With equities, you may get a dividend, and on top of that, you’re hoping for the value of the shares to go up. You want today’s $10 shares to be next year’s $15 shares, and so on. It comes down to higher risk = higher (potential) reward.
One last point I’d make on credit funds is liquidity: how quickly and easily can you get your cash out of the investment?
It depends on the nature of the product you bought. It could be a day or two … or it could be years, which is what the Mayfair 101 investors are looking at.
Be sure to look at how ‘liquid’ the underlying investments are. The reason Mayfair money is frozen is that a bunch of it is invested in a tropical island in Queensland – not the kind of thing you can offload on Facebook Marketplace. But a more vanilla type of fund may offer you good liquidity and easy withdrawals.
The key is to read the fine print, and ensure that the ‘redemption’ process is aligned to your needs and expectations.
Ok I know this is a long post so I will leave you there. But next time you see an ad or hear a person recommending a ‘term deposit alternative’, take time to look at what’s under the bonnet of that product and make sure it’s right for you.