BCP's Guaranteed Absolute Return Fund

[Brendan Burgess]

Rory Gillen has done an excellent analysis of this bond [broken link removed].

For me, the following is the nub of the issue. If an investor is looking for the diversification that hedge funds offer then why is there a need for a guarantee? Guarantees costs money, and, like insurance, the cost of hedging goes up when everyone wants it. Admittedly, in this case, with the Irish banks desperate for customer deposits, the hefty entry costs to the BCP fund of 5.4 per cent are being picked up by Bank of Ireland. So good luck to BCP, I can’t fault the firm for that.

I see the guarantee as a distraction, a tool that product sellers in Ireland use to sell to a risk-averse public. But investors must remember that, on average, better than cash deposit returns can only be obtained by taking on risk. The trick is to understand whether the asset in question is priced properly relative to the risk involved. That is surely the role of an investment advisor – to assist clients in this regard. How can the industry offer this service if it gets paid from the product and not by the client?

 

[Duke of Marmalade]

I agree that it was a good critique, but I did not agree with that particular paragraph.

A Tracker Bond consists of two parts, the guarantee part and the option part. It is not true to say that the option part has been insured, it is a separate investment with the full high risk/high reward attributes of an option.

What the punter is doing is making this very high risk/high return investment with the future interest she could otherwise have earned if she had put the whole lot on deposit.

Now to the purists there is no difference between future interest and current capital, it is all the punter's money. Yet this misses a huge emotional aspect of the ordinary punter psyche, they regard future interest as easy come/easy go and whilst terribly risk averse with their capital do not mind having a punt with their interest. There has been a parallel thread on Prize Bonds where this psychological dichotomy is taken to its extreme - people who are fearful of losing their capital are prepared to gamble unborn interest.

In the case of Prize Bonds there is of course no financial rationale as the risks do not of themselves bring an expectation of higher rewards, so that is gambling for its own sake. As long as punters know that, and Prize Bonds are very transparent, it is ok that some will take that punt with their eyes wide open.

In the case of Tracker Bonds, provided the option has been priced fairly, there is a strong rationale for expecting on balance to get a higher return than the interest that is being foregone. It is a valid retail proposition IMHO.

Now back to the BCP product, the analysis reveals that the cost of the guarantee bit is 71%. Now over 5 years and 3 months that is almost 7% p.a. If we think BoI is safe and I agree with the analysis that it is (in any case is this not covered by the various guarantee schemes?), this is a whopping good return, easily compensating for the charges.

Unless there are other hidden pitfalls, it looks on the face of it a very attractive product. What puzzles me is why BoI are not offering 7% fixed rate bonds stand alone or why they are not using a more vanilla underlying, do you really trust these hedge fund things?

What is objectionable however is the outrageous use of past performance to promote the product. I though the Consumer Protection Code banned this for Tracker Bonds.

 

[Rory Gillen]

I might add some further observations - one can deal with only a few issues in 800 words in a Sunday Times article.

The 7% return that BOI is offering might be explained by the fact that the bank could use the monies to buy back its own debt at even higher yields - which begs the question - is there counterparty risk? I, like you, have concluded no but I would not be comfortable overly exposing myself or clients to the situation. Last year, a guarantee from the Irish Government carried little weight in the markets, although the situation has improved considerably with the ECB's intervention pre Christmas.

So, back to the nub of the point I wished to emphasise - why pay for a guarantee? the alternative to the BCP product is for an investor to buy high yielding BOI debt and a hedge fund(s). Because that, in essence, is what investors' are buying when they invest in this BCP fund - do they understand that? I doubt that they do.

Both asset types are quoted on the stock exchanges and can be bought through a stockbroking account. They are both risk assets, and assuming they are fairly priced for the risk then they are 'alternative' assets and might sit well in a properly diversified portfolio. And for the many investors who don't know their way around the alternative asset classes like this, then simple structured products have a place - and traditionally this was the job of a 'balanced fund'.

I see no place in the mix for guaranteed funds, especially guaranteed hedge funds. The same protection can be just as easily obtained by a decent allocation of one's pension or savings to cash deposits or short-term bonds (non-risk asssets). For these reasons, it remains my own view that the sooner the commission-driven product selling system is changed the better. For as long as it remains in place, there will always be someone dreaming up new ways to disguise risk without actually lowering it.

Guaranteed funds may remove the risk but they are as likley to also remove the income. There is no free lunch in markets. If you want the return, you must take the risk. The equity markets have delivered 9% per annum over the long-haul and there is no asset class that has bettered that. To get that 9%, you must both avoid overvalued markets and keep costs to a minimum. Guaranteed product simply add to the cost.

 

[Duke of Marmalade]

Rory,

I want to avoid semantic debates and I agree with you on two key aspects:

1) There is no such thing as a free lunch
2) Beware commission driven advice

However, I think I disagree on the following points:

1) 7% BoI return is a whopping good return especially if guaranteed by the State
2) Whilst the State may well default on sovereign debt, hence returns of c.7% in the secondary market, there is almost no chance that it will default on deposit guarantees or Post Office savings certs for example. This mistake is often made, the State in not a corporation, a corporation has to default on its creditors more or less equally, the State can chose who to default on
3) The punter is not paying to insure the return on the hedge fund. These are essentially two different investments, one a deposit, one an option. There is no guarantee whatsoever on the option, the punter is fully putting her interest at risk, hence they do enjoy the full risk reward trade off of an option.

 

[Rory Gillen]

Begs the question then - what is the guarantee for at all. If I were BOI, I'd just advertsie that 7% rate for 5-year money. In the BCP product, the 'punter' does not get the 7%, it all goes on a hedge fund that might or might not have another good stretch. You clearly have a good understanding of these issues, but 'punters' don't, and the system is promoting this kind of kamoflage.

That's me done - like you, I don't use this website to debate but rather to assist in answering queries.

 

[Duke of Marmalade]

Correction to my earlier comments. There probably isn't a State guarantee as the term is longer than 5 years, indeed that may be precisely why the term is 5 years and 3 months.