Guaranteed Endowments: understand the risks

Guaranteed and linked endowments are a valuable option for many investors, but as with all investments, it is imperative to understand the inherent risk.

Investors often take comfort in capital guaranteed products, like fixed deposits, money market funds, retail bonds or guaranteed endowments (also known as Fixed Bonds). All these products guarantee the security of capital, but with fixed deposits, retail bonds and guaranteed endowments, the interest on capital is also guaranteed if held to maturity.

A guaranteed endowment (or Fixed Bond) may be an ideal investment vehicle for an investor looking to preserve his or her capital, and either guarantee a level of capital growth or a fixed term income. Fixed Bonds also come with all the potential tax advantages of investing via an endowment – the guaranteed maturity value is not taxable on withdrawal, and the guaranteed returns are quoted after deduction of tax. Investors do, however, need to be prepared to commit to a 3, 4, or 5 year term.

Understanding the risks

As with all investment promises, it is important to understand the risks that are inherent in the solution offered. In the case of guaranteed endowments, these risks are not immediately obvious, but defaults in international markets should give anyone pause to consider the soundness of the guarantees on offer.

Counterparty risk is the risk to each party of a contract that the counterparty will not live up to its contractual obligations. In most financial contracts, counterparty risk is known as "default risk".

Linked endowment: increased risks

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 assets held by the insurer. Linked endowments therefore introduce additional counterparty risk to a potential investor.

This means that there are two or three counterparty risks present in the linked endowment structure. The following diagram illustrates this point:

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).

Credit ratings

The ability of each of these parties to hold up their end of the bargain is thus critical. Credit ratings are available for most of the companies providing guaranteed and linked endowment structures, and these ratings can provide an indication of the possibility of default. For example, the market generally expects A-rated debt to offer a premium of 1% p.a. to 1.5% p.a. above 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% p.a., then A-rated debt should offer a return of 11% p.a. to 11.5% p.a. It is important to enquire whether there is any additional counterparty risk as it is not always clear whether the endowment is a fully guaranteed or linked structure.