Monday, June 9, 2008

The price of being financially unsophisticated

This post is timely given the recent interest in OCBC preference shares. The Sunday Times had a good article explaining the difference between fixed deposits and preference shares, highlighting the fact that most people only focus on the superior yields of the shares.

I'm going to talk about a kind of investment that I almost never use. I'm talking about fixed income assets. It's quite a deviation for me, considering that I invest my money mostly in equities and related assets. But considering the poor financial literacy of many people I know, this post might make useful reading. A caveat though, I use financial jargon here so some terms may be confusing. The gist of this post should be clear enough though.

First, let's talk about why I don't invest in fixed income assets -
bonds, money market funds and time deposits. While preference shares behave mostly like bonds, I will not include them in this discussion as they rank after debt in receiving the residuals following liquidation. Preference shares are equity, and as such have considerably higher credit risk in the event of default.

With oil trading at about $135 per barrel and food prices soaring, inflation is on the minds of everyone, from policymakers to CEOs to the proverbial man in the street. Under inflationary circumstances like now, fixed income assets are a poor performer in real terms. By definition, any asset that returns less than the rate of inflation is losing real value, and most fixed income assets today fall into this category due to low interest rates and high inflation rates (which may also be understated due to the vagaries in computing the CPI). In financial parlance, real interest rates today are mostly negative, so fixed income assets are almost definite loser investments.

Yet, most people find themselves uncomfortable with volatile investments like equities or equity funds. Indeed, due to poor market sentiment, equities in the near term are probably poised for even greater losses than have been seen so far. Hence, "no-risk" investments like time/fixed deposits are still where most people in Singapore put their money, even if they are loser investments in real terms. Even investors accustomed to risk-taking like myself find fixed income assets suitable places to park my money while waiting for new opportunities to surface, or for conditions to stabilize.

So if you must invest in fixed income, which fixed income assets to invest in? For myself, liquidity trumps return, so I leave most of my cash in my brokerage account, which earns a money market rate of return while being highly accessible for purchases of stocks.

But this post isn't about me. It's about the vast numbers of people in Singapore who place their very substantial savings in fixed deposits for fear of market volatility, and for lack of financial sophistication.

A quick check turns up fixed deposit rates here and here. The rates are truly dismal, obviously. And the marginally better rates require large amounts of cash to be placed on deposit.

Now let's look at Singapore Government Securities (SGS). For the uninitiated, and you know who you are, SGS are bonds and Treasury Bills (T-Bills) issued and backed by the Singapore Government, which, owing to decades of fiscal surpluses, is triple super duper whammy A rated.

The indicative "interest rates" or to be technically correct, yields to redemption, for the most recent tranches are here for 3-month T-bills, 1-year bonds and 5 or 10-year bonds. Look at the average yields. They are much higher than fixed deposit interest rates offered by the banks (though still lower than the rate of inflation).

SGS are open for investment to retail investors as well as institutional investors and the minimum denomination is SGD1000. Based on yield (clearly better), minimum investment (only SGD1000), security (backed by the Singapore Government for the full face value, and not just the first SGD20000 in deposits) and duration (as little as 91 days), they are clearly better than fixed deposits. On the measure of liquidity, SGS are slightly less liquid than fixed deposits and incur dealing costs (but not at subscription and not if held to maturity), but these are probably comparable to breaking the term of a fixed deposit before maturity.

In short, SGS are a closer equivalent to fixed deposits than preference shares can ever be, and they are superior to fixed deposits on almost all measures.

So why don't more people invest in SGS instead of fixed deposits? Simple, ignorance. Most Singaporeans have poor financial literacy, and also lack the skills to look for information independently. Furthermore, while the Monetary Authority of Singapore has appointed market makers for SGS, it is simply not in the interest of these dealers to cater to retail investors. Too administratively costly. So the primary dealers don't advertise this service.

Instead, they advertise their fixed deposits and the "attractive" interest rates. You can bet that some of this money that the banks get from depositors ends up in SGS. What is the price of being financially unsophisticated? One answer could be the spread between fixed deposit rates and SGS yields.

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