Investment insider: Low interest rates should not mean lower standards

 

Strange things can happen in a low-interest-rate economy. For instance, the interest that we earn on our savings has dropped to such pitiful levels that our nest eggs are losing money in real terms.

Investors looking for alternatives to cash savings are therefore forced to choose from three of the other four main asset classes – namely shares, property and bonds. Risk-averse investors are unlikely to warm to shares even though the stock market has historically delivered inflation-beating returns, and property means spinning the roulette wheel of bank lending criteria.

Bonds are IOUs: bondholders are in effect lending money to a company or a country at a suitable rate of interest that compensates them for the risk.

The glut of cheap government bonds issued through the quantitative easing programme has pushed bond yields down to unattractive levels. This has enabled businesses to also offer lower yielding bonds, even if the interest rates may not properly reflect the riskiness of the loan.

But in a low-interest-rate economy almost anything goes, as investors are presented with a choice of taking it or leaving it. Often they will take it.

One of the first companies to sell bonds direct to its own customers was the shaving supplier King of Shaves. About three years ago, the company offered £1,000 "shaving bonds" to shaving enthusiasts. The yield was 6 per cent, which might not fully reflect the risk of buying unlisted bonds in a relatively unknown company.

The upmarket confectioner Hotel Chocolat also went down the direct-to-customer route, but with a twist. It raised more than £3m by offering bonds to chocolate lovers. But instead of cash, interest of up to 7.29 per cent was paid in deliveries of chocolates every two months. More recently, John Lewis gave staff and customers the chance to earn up to a 6.5 per cent by lending the company money. The bonds paid 4.5 per cent, topped up with 2 per cent in John Lewis vouchers.

The attraction of bonds is easy to see, but bear in mind a few things. First, the yield should properly reflect the lender's risk rather than what the company thinks it can get away with. Second, remember with fixed-rate bonds that inflation may rise faster than expected. Finally, just because we are in a low-interest-rate environment, we shouldn't lower our standards.

David Kuo is director of fool.co.uk

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