When bonds are dangerous: A history of products from banks

bonds-are-dangerousBanks in Singapore are known to be safe and relatively conservative institutions. But that doesn’t mean they haven’t sold products to unsuspecting people. People who shouldn’t be any where near the sophisticated instruments.

Products appealing to the Asian investor

Let’s take a look the average Asian investor, what are they concerned with?

Most “investors” in Singapore seem to be concerned with loss avoidance. People are afraid to lose money. This leads to bonds being very attractive. Bonds are “safe” because of these properties

  1. Principle is returned on maturity
  2. The interest rate is guaranteed
  3. If the company goes bankrupt, bondholders are paid first from any remaining cash


So looking at these points, it seems like a bond is almost like a fixed deposit. The main difference is point 3. A bond is a loan to a company. Have you ever had to get a personal loan from the bank? The bank decides an interest rate they want to loan you money based on how trustworthy you look. (based on your credit rating, annual salary, and the fact that your promised them your soul). This interest rate is based on how likely you are able pay the loan back.

In the case of a bond, you are playing the role of the loan shark to company. The company that issues the bond is essentially promising you interest for loaning money to them. Yet, it seems like the banks have marketed a number of “bond” products that aren’t.

Products banks have marketed over the years

I’m going to look at some of the products the Singapore banks have marketed over the years mainly, the United Capital Guaranteed Funds 80PLUS (A safer tech option), the famous Lehmann mini-bonds, and the recent Swiber saga. These products have been marketed as “safe”.

United Capital Guaranteed Funds 80PLUS (A safer tech option)

This was a product that UOB Asset Management launched in 2002. It’s eons ago but I like to use it as an example because there’s a huge difference between how the product was marketed and what it actually is. This was recommended to my older relatives as a “safe” investment.

“United Capital Guaranteed Funds 80PLUS offers potential returns of 80% with a 100% capital guarantee after a 3% sales charge; is the first such product in the retail investment sector. There are no penalties for early withdrawal. About 90% of the funds will be invested in bonds and the rest will be used to buy options and pay the manager’s fees”

Straight off the bat, they are throwing in lots of perks to appeal to the Asian investor. People who don’t invest tell me their expected return on their investment is 30 to 80% per annum. (not gonna comment on whether that’s realistic). But an investment such as this with both capital protection and “potential” for high returns is sounds like a god-send. And the capital protection is guaranteed by bonds, so what could go wrong?

Let’s read the fine print:
The fund’s returns are based on monthly performance of Nasdaq 100 Index.

An 80% return is allocated to every investor at the outset. For every month that the Nasdaq 100 Index registers a negative return, the corresponding amount is deducted from the 80%. When the fund matures in 3 years, whatever is left of the 80% is given back to the investor as his earnings.

Sidenote: It uses NASDAQ 100 as a benchmark. The NASDAQ 100 is an index of 100 non-financial institutions listed on the NASDAQ stock exchange. You can think of an index as an average of these 100 companies.

So let’s break these sentences down. An 80% return is given to you at the start and every time the Nasdaq 100 goes down,  the corresponding amount is deducted. Meaning if this month the Nasdaq 100 goes down by 5%, your potential return is immediately down by 5%. And we know that historically, stocks are volatile in the short term.

The only way you could have 80% return in this fund when the NASDAQ registers a gain EVERY MONTH. You’re more likely to get eaten by an alligator while jogging around MacRitchie. And if you think it’s going to go up every month, why not just buy a NASDAQ 100 index fund? Because this fund limits your return to 80%, if your view is that the NASDAQ is going to go up every month for the next 3 years, why limit your maximum return to 80%?

Unfortunately, exactly nobody who were marketed this product thought of it that way. I talked to a number of them and all they could tell me was that the capital protection and potential to make 80% ^_^

Lehmann Mini Bonds

This product was the punch-line to lots of jokes in 2008. Should it be considered famous or infamous? Everybody who invested in this product thought it was bonds issued by Lehmann and guaranteed by DBS bank for some reason.

Did nobody ask why there’s a need for the word MINI if it really was about bonds? A bond is a bond. When it’s a mini- bond, it’s no longer a bond. 

It’s actually a synthetic collateralized debt obligation. I know that’s really technical so I’m going to enlist the help of Selena Gomez to explain it.

In essence, it had nothing to do with a bond. It’s a derivative; a derivative like Selena says is a side bet. The safety of a bond comes from the fact that bond holders are paid before shareholders when a company gets liquidated.

With a derivative, you don’t get anything as you’re essentially doing a side bet with someone else, you do not own the debt of the company in question.

So again this product was marketed to people who thought that bonds = safe, Lehmann, big American bank = safe, my investment = safe. 

SWIBER bonds saga

Now we came to the latest saga. This one is bit less complicated as it didn’t involve deceptive products. It was a simple case of banks marketing bonds of a company to “accredited” investors. An accredited investor has: 

  1. NET Personal assets exceeding SGD 2 million (or equivalent in foreign currency). Or
  2. Income in preceding 12 months of not less than SGD 300,000 (or equivalent in foreign currency).

The banks can offer you more products once you become an accredited investor. The thinking behind this whole accredited investor thing is that since you have a lot of money you can afford to lose some of it on dumb investments. The other implication is since you have a lot of money, then you must know something about money and you won’t make dumb private investments.

This is pretty dumb thinking: people who have just crossed these thresholds can’t even be considered “rich” in Singapore. And there are plenty of lawyers who don’t know anything about investing. 

In the case of the Swiber bonds, people concentrated on the high yield and forgot about the likelihood of default by the company. In the words of one of the investors, he “thought” Singaporean banks would not market “risky” products.

To be clear, Swiber Holdings isn’t a fly-by-night company. It is a big in oil and gas firm listed on the main SGX board listed. The company owns 13 construction vessels and has more than 2,700 employees

The problem was this: people were being lulled by the false illusion that products marketed by local banks are safe and conservative because the bank itself is safe and conservative.

Conclusion

The main takeaways are not to let the reputation of the firm affect the investment you are getting into. We need to interrupt the decision flow of big firm = safe and won’t cheat me. (If you think about it, big firm = won’t cheat me is like saying I’m a vegetarian = I know karate, the correlation makes no sense).

This is easier said than done for many of us, that’s why our investments should be automated.

The 2nd point is: DO NOT INVEST in high yield bonds. There’s definitely a place in some portfolios for high yield bonds. But it’s not in YOURS. If someone tells you about high yield bonds, start replacing the words high-yield with the word junk. Do you want to invest in junk bonds? (This is the actual financial jargon for such bonds, cross my heart)

We’ve spoken about diversification before, and bonds have a place in every portfolio but we’re talking about high grade government bonds. The easiest way to get started is to buy a bond fund.

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Comments

  1. Thanks. Interesting to know what “Mini” actually means. Wow !

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