Which investments are ‘safe’?
Starting with chapter 4, the book starts to get into the meat of the business of investing. Enough with the financial foreplay!
These are the terms I needed to research for what kinds of investments should go into the security bucket of our asset allocation.
Cash & cash equivalents
Cash and cash equivalents are short-term tactical investments. Unlike equities, they are unlikely to decrease in value – but equally, they might not keep pace with inflation. The money in your current account is a cash equivalent, so too is the money in your cash ISA or savings account, as are short-term government bonds (gilts). Think low-risk, low-return. You can readily convert cash equivalents into actual cash.
Bonds are loans or IOUs where you are the bank. You lend your money to a company, a local council, the government – and they promise to pay you back in full, with interest. Typically, bonds are seen as safer and more stable than equities, because insolvency-wise, bond-holders outrank share-holders when the organisation is liquidated and the cash is divvied up.
TIPS (Treasury Inflation-Protected Securities)
In the UK we call them index linked gilts and they’re issued by the government and do pretty much what they say. You get your money back + interest + an adjustment for inflation. In terms of security, this is about as good as it gets.
When the UK government issues a bond, it’s called a gilt. This quaint and confusing terminology comes from the original (paper) bonds being gilt-edged.
US Treasury Bonds
For the UK, see above. Gilts (bonds) issued by the UK government may, or may not be, index-linked.
The following description makes me thing the UK debt office doesn’t want me to understand what T-bills are:
Treasury bills are zero-coupon eligible debt securities and can be held in CREST and Euroclear.
Oh, really? So, T-bills, or Treasury Bills are like gilts but much shorter-term. They pay no interest, but, they are sold below face value. So, you might get a 21-day T-bill with a face value of £100, but you actually pay £98 for it. In 21 days’ time, the government pays you back £100 and you’ve made £2 – yay! That’s all fine and dandy, but UK T-bills currently yield approximately nothing.
In the US, a T-note is an intermediate-term interest-bearing bond issued by the US Treasury. In the UK, it was a currency note, last issued by the Treasury in 1914, and valid until 1928. It seems we no longer need to worry ourselves with T-notes here in Blighty ..
A marketable, fixed-interest U.S. government debt security with a maturity of more than 10 years. Treasury bonds make interest payments semi-annually and the income that holders receive is only taxed at the federal level. As far as I can tell, there is no UK equivalent.
A corporate bond is similar to a government bond (gilt) but issued by a company. They are usually issued as a way for a company to raise cash, and are essentially certificates of debt. When you buy corporate bonds you are lending money to a company in exchange for an IOU. The IOU is returned in full at the end of the term and interest is paid annually or bi-annually (also known as the coupon).
Corporate bonds are seen as slightly higher risk than gilts because it’s less likely that the government will go broke.
For example, Hargreaves Lansdown list corporate and non-gilt (non-government) bonds. Some of the terms and coupons seem quite attractive: A 21-month bond issued by BT paying 8.75%.
You guessed it, your local council can also issue bonds to raise cash. Depending on the council, this might be seen as more or less risky than a corporate bond. This recent FT article says that this will likely become increasingly available as an investment option.
Aside from actually purchasing residential or commercial property and gaining an income via rent or realising a capital gain by selling it, there are a couple of investment vehicles that allow you to invest in real estate without directly purchasing it. As an asset class, real estate is in this security bucket because it is a tangible asset – it will probably always have some value above zero.
First Trust Deeds
A first trust deed is a mortgage that has priority over all other mortgages or trust deeds. If the lender of a first trust deed forecloses, all other mortgages, liens and trust deeds are negated. Clearly, if you want to lend money to finance a property, you want to be first in line if things go wonky.
This is probably of only hypothetical interest in the UK because I couldn’t find any mention of trust deeds as an investment option, just as part of a legal mechanism to record debt.
REITs (Real Estate Investment Trusts)
On the other hand, REITs are getting bigger in the UK. You can see a list of current REITs here.
When you buy a REIT, you are essentially buying shares in a company whose primary activity is investing in property. In this sense, a REIT is a hybrid investment in equities and property. Your direct investment is essentially in the equity of the REIT company – and their investment is directly in property.
The advantages are that you can own a share of multiple properties – commercial and residential – without actually purchasing the properties. The investment is more easily tradeable than the actual properties, so there are advantages of improved liquidity and reduced transaction costs. There’s also the ability to diversify between real estate markets as a REIT doesn’t have to be dedicated to UK property. REITs can also be very tax efficient, as the property company pays no corporation or capital gains on the profits made from property investment.
The disadvantages, as far as I can see, are that your investment is only as good as the company issuing the REIT – so it definitily involves some of the risk of making a direct equity investment. There’s also the risk of some disassociation between the value of the underlying assets (the actual property portfolio) and the value of the REIT. Imagine the scenario of a stellar property portfolio being managed by a sub-par company with excessive overheads: That would negatively impact the value of your REIT investment.
I’m interested enough in REITs to investigate further, and because there is an asset base with a fundamental value above zero, REITs could belong in my security bucket.
However, think back to 2008 when all the toxic mortgage-backed investments came to light. Some of them were rolled-up into REITs – and some investors lost out in a big way.