The game of risk vs. reward when it comes to investing into debt

Post by Dave Tyrer - Squirrel COO

The average bank customer probably doesn’t think about it quite like this, but one of your bank’s main roles is to be the middleman, or intermediary, between borrowers and depositors.

What I mean by that is that when you hold money with a bank – be it in a transaction or savings account, or a term investment – it doesn’t just sit there.

The bank manages the process of lending that money out to borrowers in the form of all sorts of different loans. Home loans, credit card debt, overdraft… You name it.

It sounds simple enough, right? But it’s actually incredibly complicated.

A big part of the job is about managing credit risk and liquidity risk on behalf of any depositors.

Credit risk is stuff like figuring out whether (or not) to lend to certain borrowers, and what happens if a borrower doesn’t make their payments or defaults on the loan. Liquidity risk, meanwhile, is stuff like managing what happens if a depositor needs their money back but the borrower hasn’t repaid.

And then there are a gazillion laws and regulations to comply with, and lots of customers to keep happy along the way on both sides of the ledger.

The banks are really good at all of this – and as payment for the service they provide they take a margin, being the difference between the rate of interest they charge on money they lend and the rate of interest it pays you for your deposit.

That margin has to be adjusted for costs and losses along the way – and there’s a degree of interest rate risk that has to be managed as well.

Certain types of loans generate far better margins for the bank than others. But savers earn the same no matter where their money goes.

In Aotearoa, the major banks are basically the same in the proportions of lending they make to each borrower segment.

The rates the banks charge vary massively by loan type – with credit cards being the highest. Here’s the latest Reserve Bank data, which gives you an idea of the current rates out there:

• Home Loans – banks currently lend at 5.07% p.a. on average
• Credit card debt – banks currently lend at 18.90% p.a. on average
• Business loans – banks currently lend at 7.74% p.a. on average
• Business overdrafts – banks currently lend at 12.66% on average

Source: RBNZ statistical series July 2023

Those are some tasty returns if you could lend directly, right?

But the banks don’t give depositors direct access to the underlying types of loans – instead they pay a blended return, dictated by the bank and level of competition for deposits.

So, why won’t banks let you choose where your money goes?

The short answer is that they’re trying to maximise their margin, by keeping the cost of deposits (what they pay you) as low as possible and borrowers’ rates as high as possible. In the case of term investments, banks focus on the length of the term to dictate pricing.

Competition on deposit interest rates and borrower interest rates can limit just how big that margin might be at any given time.

If you simplify the equation down, the table below gives you an idea of this works with some (made up, but still) realistic numbers for a business loan: 

But banks aren’t your only option when it comes to investing in loans or “debt”

There are actually lots of alternatives out there in the form of things like Fixed Interest Securities, Managed Funds, and Debentures.

These options let you buy directly into certain types of debt – and they can be extremely specific, sometimes getting right down to individual borrowers.

Milford Asset Management’s Global Corporate Bond Fund is one example. Basically, you’re investing in bonds as a form of debt issued (or taken out) by global corporates, so they can do things like expanding operations or otherwise growing the business.

These options give you direct exposure to the asset class of your choosing – very different to how your funds are invested when you make a deposit with a bank – but you’re typically still paid a regular interest return.

In these instances, credit risk assessments will be carried out by a fund manager, who will do an analysis of the underlying companies, and manage diversifying investments across a range of different bond issuers.

Liquidity risk, meanwhile, is managed via the ability to sell bonds to other investors. So, if, you want your cash back, the fund manager can sell some of the bonds they’re holding to get the cash and pay it back to you.

And then, there’s investing with Squirrel.

At Squirrel, we’ve taken a different approach again, giving investors the ability to choose exactly the level of risk they’re willing to take.

Credit risk

As an investor, you choose how you invest your funds depending on your appetite for risk – and as usual, the higher the risk the higher the returns.

To help investors make their decision, we track the credit risk across our various loan portfolios (as they relate to our different term investment classes) and display all that information available on our website.

So, for example, if you fall at the more conservative end of the scale, then investing in our Home Loan Term Investments could be right for you.

Currently, our Home Loan portfolio has a credit risk of 0.04% - which is pretty close to 0%, making it relatively low risk. Contrast that with our Construction Loan Term Investments, which currently have a credit risk of 0.39%, so quite a bit higher. And the credit risk on Personal Loans steps up again to 0.87%.

In addition to explaining the scale of risk of each Term Investment class, Squirrel also has Reserve Funds – similar to a bank – to protect our investors against loan losses. You can read more about our Reserve Funds on our website.

So, we’ve still got measures in place to help manage Credit Risk – we just do it slightly differently to the banks. The big benefit here is that our investors get to choose the level of risk they want to take, unlike a bank.

Liquidity risk:

We allow you to get your money back before your term investment reaches maturity, via our secondary market – where you have the option to list your investment for sale, so it can be snapped up by another willing investor.

Our secondary market is free to use, and you continue to earn interest right up until the day your investment sells.

We regularly publish updated stats on our website around how long it’s taking (on average) for investors to sell, and how much is being traded between investors.

There is a risk that no one will be willing to buy your investment, in which case you may need to hold it to term – and that’s a risk that investors need to consider.

So, credit and liquidity risks are still there when you’re investing with Squirrel, we just manage them slightly differently to how the banks do.

Overall, the main difference is that, compared to the banks, we let you be more hands on in choosing exactly how much risk you’re comfortable with.

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The opinions expressed in this article should not be taken as financial advice, or a recommendation of any financial product. Squirrel shall not be liable or responsible for any information, omissions, or errors present. Any commentary provided are the personal views of the author and are not necessarily representative of the views and opinions of Squirrel. We recommend seeking professional investment and/or mortgage advice before taking any action.

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