Daily Commentary BY THE CURVE TEAM –

Weekly Insights – Investment Risk

27th of September, 2021

Key Updates

Tuesday – Retail Sales for August

Thursday – Building Approvals for August

Friday – Housing Loan Approvals for August

Understanding Risk

For the organisations we speak to at Curve, risk is extremely important. Specifically, the preservation of capital, i.e., having invested funds returned is the main motivator when choosing investments. Fixed income as an investment is safer than other option like equities, so attracts investors whose goal is to ensure funds are safe and returned, while earning the highest return within these parameters.

This fixation on risk can lead to unnecessarily conservative approaches though. Rather than having a wholistic view of risk, organisation can take a narrow view, such as focusing on one financial ratio or a media article.

Below are factors to consider when thinking about the risk of fixed income:

  • Term Deposits have a government guarantee up to $250 000 for domestic ADIs – Unless you have an opinion that the government will renege on this, there is no justification for holding no money with an ADI (even an unrated ADI) on the grounds of risk. You should have at least $250 000, and for investments higher than $250 000, the investment up to $250 000 is guaranteed, which reduces the loss in the very rare event of default.
  • APRA Regulation is Stringent – ADIs are required to hold a minimum amount of high-quality assets for times of financial stress. A ‘Regulatory Disclosures’ section is available on all ADI websites to verify the capital position of ADIs. The riskiness of the loans ADIs write are also heavily scrutinised. This significantly reduces the chance of default, with there being no defaults since APRA took responsibility of credit unions and building societies in 1998. This is not to say defaults are impossible, but they are very unlikely.
  • The Capital Structure Minimises Risk Significantly – Even if there is a default, this does not imply all invested funds are lost. The capital structure (in the feature image) shows the priority of payments if there is a default. Covered bonds, cash accounts and term deposits are the first priority. Therefore, there is the possibility that all the funds, or part of the funds are returned. To be concerned about the risk of term deposits, cash accounts and covered bonds is not just assuming a default, but that the default will be so extreme that even the highest priority of payments will not be paid out. This is very unlikely (not impossible).

Based on the above, two examples of overly conservative investment policies which slaps in the face of the above are:

  • A reluctance to invest in term deposits – For example, many organisations do not allow or limit the amount of term deposits that can be held with ADIs with credit ratings below the majors or an A rating. This ignores the fundamental safety of term deposits. Even if organisations want to err on the side of safety, they could at least allow $250 000 with ADIs.
  • Not allowing covered bonds – As explained above, covered bonds are the highest priority of payment, and have specific collateral that must be held against them in an event of default. ING and CIBC recently issued covered bonds. To not allow bonds in an investment policy, regardless of whether they are covered, is unnecessarily conservative when they are equivalent to cash accounts and term deposits on the capital structure.

This is a very basic overview of the risk of some of the investments Curve assists with. For a more thorough understanding of the above or other investments, such as FRNs, foreign ADIs and so on, feel free to reach out to us.

Josh Stewart

Associate - Money Markets