I am a 75-year-old married man without a pension. However I have a small income of between R10 000 and R15 000 per month, via working from home manufacturing a safety device for kids. I also have little more than R1.5 million in cash, which at present is in an FNB Money Maximiser account which pays me 7.35% pa or about R9 200 pm.
On researching to see if I could get a better return on the R1.5 million, I came across a FedGroup advert offering 12% via its bond participation scheme. However, I also found an article on its deal with Investec, which seems to have gone a bit sour.
In light of this, do you think my money would be safe with FedGroup or would I be taking an unnecessary risk? I.e. is FedGroup a reliable and stable company or should I place my money elsewhere ?
Craig Gradidge - Gradidge-Mahura Investments
It is great that you’ve chosen to investigate further and haven’t simply gone for the highest yield that you could find. There is usually a strong correlation between yield and risk. Higher yields imply higher levels of risk. This is also the case in this instance, despite the guarantee that comes with this investment.
When you mention participation bonds, investors often think back to the devastating impact that Masterbond had on its investors when it collapsed in the early 1990s. The product’s image was not helped by the unsuccessful legal action by Investec against FedGroup (then Fedbond). More recently Absa decided to exit the market leaving FedGroup as the sole player in the market.
Let’s take a closer look at the product, the company and the overall investment proposition.
Bond participation schemes, more commonly referred to as part bonds, are collective investment schemes regulated by the Collective Investments Schemes Control Act (2002). This is the same regulation that governs products such as unit trusts and exchange-traded funds. The client’s money is invested in an underlying debt instrument which then loans out the funds for the development of various properties. According the person I spoke to at the company, it looks as if the fund itself owns the properties.
There are also rules which the scheme must follow which ensures stability and security. One of these rules is that no more than 75% of the value of the property to be mortgaged may be lent out. The remaining 25% stays in a pool that can be used as a buffer if needed. Risk is also mitigated by spreading the funds across a portfolio of properties. These properties are used as collateral for these loans, so there is an asset of value that can be attached in the event of default. FedGroup has maintained payments to investors over the past 26 years that the fund has been around. This is a solid track record and a feather in its cap, as it maintained payments through the various challenges it faced, and through different market conditions.
While the fund’s fact sheet (minimum disclosure document) shows a fee of 0%, investors effectively pay for the product by way of a lower yield. There is absolutely no way that a for-profit company would incur the costs of administering the product, preparing and distributing statements and tax certificates, and deal with client queries, all for free. It would be great if there was a bit more disclosure around the cost to the client.
The product lacks liquidity in the first five years and the capital becomes available after that period. This lack of liquidity is an important consideration for potential investors, but not necessarily a deal breaker. Investors wanting to compare rates can look at five-year fixed deposits and retail savings bonds to see what they can earn with the same level of liquidity. The nominal rate on the RSA Savings Bond with a five-year term is 8.50%. This lower rate reflects the relative riskiness of these products.
The fund currently has over R1.5 billion invested in it from 6 000-plus investors. This is the sum total of the market, as there are no alternatives available to investors at this stage. This is also an important consideration for a potential investor, but not a deal breaker either.
The product provider
FedGroup is a diversified family-owned financial services business. In addition to the part bonds business there is an asset management business, financial planning, a life company and other related businesses. It seems that the businesses are all owned by FedGroup Financial Holdings Pty Ltd. The company is led by industry veteran John Field who founded the business in 1991.
As it’s a private company, it is difficult to determine the financial stability of the business. However, the various businesses would have to submit financial statements to the Financial Services Board. In an ideal world the regulator would intervene if it saw that the company was in financial difficulty or if its financial position was deteriorating.
The investment proposition
The investment offers the client an ability to lock in a higher yield than he/she is currently earning. This is a good thing. However, he/she needs to be aware that their investment will earn 12% if they invest for the five-year period but reinvest the interest. If he/she were to take the interest as an income, then the rate they will earn drops down to 9.5%. The 12% rate quoted is an effective rate, and I assume the compounding period is monthly. So from an income perspective, the uplift in yield will be from 7.35% to 9.5%, not 12%.
The returns from this type of investment are all subject to income tax. With R1.5 million of your money earning interest, you’re certainly earning more than the R34 500 interest exemption. Between you and your spouse, you can earn interest of R69 000 per annum before you start paying tax on your interest income. At 7.35% pa you can invest R938 775 in interest-bearing assets. At 9.5% pa you could invest R726 300 in the part bond before you start paying tax on your interest income.
With earnings of R10 000 to R15 000 per month you have an average tax rate of between 0% and 5% pa which is low. So you are able to earn a real return (above inflation return) from interest-bearing investments. However, it seems as if you are still quite active and earning an income from your labour. This suggests that you have a life expectancy of over 15 years, almost certainly between you and your spouse. This is a reasonably long-term horizon, so you should consider some exposure to equities and other growth assets. You could allocate between 20% to 30% of your portfolio to long-term growth assets which would not only help increase your expected return, it would also be more tax efficient. Between you and your spouse, you could hive off (assign) R66 000 a year into a tax-free savings account and draw income from there tax free in ten years’ time.
If you stopped working and needed to maintain your current income level of between R19 200 and R24 200 per month, the capital of R1.5 million would last between five and seven years. So you do need to consider a portfolio that would grow capital, and produce income. Your portfolio would be able to sustain an inflation-protected income of around R10 000 per month from now until age 90 assuming a 9% pa return. Obviously, you would need to go through a thorough retirement planning exercise in order to assess your position more precisely.
I would consider the Part Bond, but not invest more than 10% to 15% of assets there, given the lack of liquidity, the size of the market, and the inability of the investor to determine the financial stability of the product provider. You would benefit from the higher yield, but you need to first compare this yield with a five-year fixed deposit or retail savings bond.
Following the publication of this article, FedGroup sent the following response:
Thanks for your comments regarding FedGroup and our Secured Investment in Participation Bonds. Like you, we believe that it provides a sound diversification tool in a balanced portfolio.
FedGroup is South Africa’s largest independent financial services provider, allowing us to make decisions in the best interests of investors. In the 26 years of this product’s existence we have always paid investors their monthly interest while their capital has remained secure.
With this in mind, we would like to take this opportunity to elaborate on a few points you make in the article.
We are proud to claim zero fees to investors, as we charge no monthly, admin, management or other fees on this product. The full amount invested accrues the 9.5% nominal rate (compounded monthly as per your assumption). The client’s money is invested in the fund, and these funds are then loaned out on first mortgages on commercial and industrial property. The fund has full security in the form of these first mortgage bonds over the properties it has lent against. FedGroup makes a small margin of between 1% to 2% on the difference between the borrowing and lending rate. The only fees paid are by the borrower.
FedGroup has recourse in claiming rights on the property in the event a borrower should default. You rightly state that no more than 75% of the value of the property to be mortgaged may be lent out. In addition, property values have increased over time. At present, the fund has close on double the ratio of security (value of the properties) to outstanding loans (value of mortgage bonds) which makes the fund very secure, with its investors well protected.
Regarding the liquidity of the offering, our Secured Investment in participation bonds should obviously be compared against similar five-year term offerings. This term allows us to manage the fund’s liquidity, in the interest of investor’s security. Many of our senior investors enjoy the option of withdrawing monthly interest should they need an income option. In addition, investors do have the opportunity to withdraw capital earlier, subject to conditions (as per other term products).
FedGroup is proud to have a positive working relationship with the FSB, which has a favourable view of participation bonds and in particular the one managed by our group. FedGroup and the Fund is subject to FSB oversight and reporting, and they have clear sight of our capital adequacy and financial position.
Should you have any further questions, or if you would personally like to have sight of our financials, please don’t hesitate to contact me.