We received an article from Old Mutual which sets out the difference between linked and guaranteed products. Hereunder some excerpts from the article which is available in full by clicking here.
Conservative investors often take comfort in capital guaranteed products, like fixed deposits, money market funds, retail bonds or guaranteed endowments. All these products guarantee the security of capital, and with fixed deposits, retail bonds and guaranteed endowments, the interest on capital is also guaranteed if held to maturity.
Linked endowments are more recent additions to the secured rates market. These endowments stipulate that the quoted maturity value is not guaranteed by the issuing insurer, but rather by the underlying instruments held by the insurer. The insurer under a linked endowment therefore introduces additional counterparty risk to a potential investor. This means that there are two or three counterparty risks present in the linked endowment structure.
For a guaranteed endowment, the client’s exposure is limited to the long-term insurer (A).
For a linked endowment, the client is exposed to the default risk of the insurer (A), the bank sourcing the debt instruments that back the maturity value (B), and the issuer of the debt instruments (C). The insurer may also source the underlying debt instruments directly, which then eliminates the default risk from the bank (B).
The ability for each of these parties to hold up their end of the bargain is therefore of critical importance.
An important indicator of the risk involved is the credit rating of the parties involved by an independent source such as Fitch. (The latest Fitch ratings for some of the products appearing in Investment Indicators appear in the full document.)
So how does a credit rating of A compare to a rating of AAA? Well, the market expects A rated debt to offer a premium of 1% to 1.5% on the interest rate offered by a AAA rated debt instrument, to compensate for the additional default risk. So if the safest debt (AAA rated) offers a return of 10%, then A-rated debt should offer a return of 11% to 11.5%.
The following steps are very important when deciding on a low-risk investment provider:
1. Is the product a guaranteed OR linked endowment?
2. For a guaranteed endowment, who is the insurer, and what is its financial strength?
3. For linked endowments, who are the counterparties to the transaction and are you comfortable about their financial strength?
4. What are the credit ratings of the counter parties?
5. Is the interest rate premium being offered sufficient for the additional counterparty risk?
6. Are you comfortable with accepting the additional counterparty risk?