Friday, April 1, 2016

Risk and Interest Rates

A friend and I were talking about possible investments for retirement a week ago, and one thing mentioned was about a time deposit account in a multi-purpose cooperative at our hometown. I was told that it looked like a safe investment, and at the same time I was told that the guaranteed return was 10 percent per annum; that is, if I choose to invest PhP 1 million, I would be guaranteed a yearly income of PhP 100K.

When I told him that I thought it was probably a risky investment, I wasn't able to explain why I thought it was so due to time constraints (I was in between classes, and had to go to another class a few moments after our discussion). So as a belated effort, I'm now going to use this place to explain just why I said it.

There are two kinds of ways you can earn money from investments: either as a business owner or as a lender. This isn't an absolute statement; instead, one can think of a continuum of states where one's income can be thought of as a combination of these two things.

For example, an employee can be thought of as being in business for himself ; the capital here is human capital, since after the abolition of slavery, each person owns himself. An employee or professional invests in education and other expenses, and sees a return on his investment in terms of wages and professional fees. You can even estimate the return on investment by using the total income generated by the person over his lifetime vis-a-vis the cost of raising that person to be a productive adult.

You can also be the sole proprietor of a business, and earn money via the net income of the business. Or one can buy stocks in companies (be a part-owner of the company), and earn money from capital appreciation and distributions of dividends.

So far, I've talked about ownership. How about lending? In lending, you are letting other people rent your surplus capital. It's rent since the agreement is that you forego the current use of your capital so that other people may use it. The people who borrow from you must pay not just the amount of money they borrow at alter date; they must also compensate you for the time in which you are unable to use the said money, as well as for taking the risk that you may not get the money back (the risk of default). Interest is charged because of these two considerations.

A time-deposit account is a form of lending. The depositor lends money to the bank, and the bank must pay the depositor for the use of this capital. Bonds are also a form of lending; the bond issuer is borrowing money from the bondholders.

The interest rates are decided via the competition between various borrowers. If Alice, for example, is more likely to default than Bob, and they both compete for the opportunity to borrow from the same lender, the lender would be a fool to charge the same interest rates. If both offer to pay the same amount of interest, the lender would prefer to lend to Bob since he will take on a lower amount of risk. The only way the lender would consider lending to Alice is for Alice to offer a higher amount of interest. Interest is therefore higher if the perceived risk of a borrower to default is higher compared to other borrowers.

So in a given market composed of borrowers and lenders, the quoted interest rates can be used as a rough measure of how risky a particular borrower is. The lower the interest rate, the lower the risk. The higher the promise of return, the greater the perceived likelihood of default. US treasury bills, for example, have quoted interest rates of less than one percent right now because lenders believe that the US treasury is least likely to default. Russia, on the other hand, has current rates of 11 percent because of the higher perceived risk; the Russian government has had a recent history of default; sometime in 1998, they defaulted on their obligations, and their lenders therefore would be foolish to lend money to the Russian government at the same interest rates as they would to the US treasury.

As another example, credit cards are really the bank offering to lend you money, with interest. To see how the bank evaluates you as a risk, look at the quoted interest rates. If your rate is 2 percent per month, this is equivalent to 27 percent per annum. You are therefore judged to be a riskier borrower compared to the Russian government. If the ban offers you a lower interest rate with lower fees, then that means that the bank has judged you to be less risky compared to the typical credit card holder.

The bonds that are considered not-investment grade are known as junk bonds. A cursory glance at the offered yields (10 percent and up) compared to other bonds should immediately signal that lending to the companies that floated these bonds is risky, or at least riskier than bonds that could yielded lower returns.
The only way to lower the risk for the borrower is to buy a diverse selection of such bonds so that the bonds that did not default would compensate for those that did. One good thing to remember is “No borrower will offer a higher interest rate if he  can get away with a lower rate.”. If the offered interest rate is high, there must be a reason for it. Lending to one single borrower is extremely risky. and if it's money that's intended for retirement, you are putting all of your money at risk if, for example, all your money is in a time-deposit with just one bank or financial institution. This is the reason why I'm not gung-ho at putting my own retirement funds in that cooperative; instead, I would put a small portion to help diversify my portfolio.

ADDENDUM: Many Ponzi schemes claim to double your money in a short time period; for example, what if someone offers to double your money in three months? This is equivalent to an interest rate of 100 perecent in 3 months or if quoted at a per annum rate, this would be at 1500 percent per annum. Such a rate should therefore be accompanied with a warning: This investment is extremely hazardous to your financial health.

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