High returns come at cost of high risk
With the property market under pressure and tougher scrutiny of potential borrowers, developers and desperate purchasers are increasingly being forced into the shadow banking market to fund their commitments. These transactions involve significantly higher interest rates and relatively short lending terms.
These shadow lenders source funds by offering interest rates much higher than those available from traditional, safe fixed-interest securities, including term deposits.
They often create the illusion of liquidity by offering generous redemption facilities. The reality is that in times of property stress and credit squeezes, investors' money can be frozen. In numerous past cases, including Estate Mortgage, Aust Wide and Pyramid Building Society, investors saw their company fail.
Pyramid customers escaped largely unscathed because of the Cain government bailout, but in almost all other instances investors lost all or most of their capital. Unlike with bank deposits up to $250,000 per person, there were and still are no protections against loss of capital.
The major lesson is fixed-interest investments offer no chance of capital appreciation, and the risk of losing capital is far higher than the benefits of receiving an additional 3 per cent or more a year in interest.
With such elevated levels of risk, it's even more dangerous for investors to put all their eggs in the one basket, as many have done in the past.
Even in superannuation funds, as ASIC recently warned, investors need to be aware of what cash and fixed-interest investments such as "enhanced cash" or "cash plus" they have. At the time of the GFC, for example, a large super fund invested its cash holdings in a bank-backed residential mortgages fund which, if the federal government had not bailed the banks out, would have become illiquid as several other mortgage trusts did.
This is a timely warning that in the financial world, what's happened in the past is likely to happen again. Self-managed funds have a greater ability to know and understand the risks of fixed-interest securities they invest in. Unlike the larger funds that can't access the bank deposit guarantee, they can shop around for the highest yield on bank deposits up to $250,000 without risk of loss of capital.
Remaining alert and being sceptical about the reasons why higher interest rates are offered is essential to help investors avoid capital losses in what should be the safest part of their portfolio.