How do tracker bonds work?

A few weeks ago, I wrote about risk and return, how the markets reward you for taking risk by giving you a great expected return. This week, I am going to write about a type of investment that is marketing as saying you can enjoy equity type returns (high risk) while taking deposit type risk (low risk). These are called Tracker Bonds or Structured Products.

How do they work?

You give your money to the product promoter who will invest the money on your behalf. They will track a selection of stocks or an indices of shares or bonds. The term of the investment is usually 5-6 years.

At the end of the term, if the selected stocks are worth more than when you started, you make a profit. If it is lower, you get your money back. There are variations of this, where there are limits on the amount of the profit you receive or only a percentage of your money is guaranteed.

How do they do this?

In essence, your money is split three ways:

  1. Most of your money, over 90%, is placed placed in a fixed term deposit account. At the end of the fixed term, the interest and the amount invested is will equal the guaranteed amount.
  2. The second amount, about 5%, is used to buy an option. That is, the promoter has the option to buy the selection of stocks at the end of the term.
  3. The last amount, about 5%, is paid to the promoter and intermediary in fees.

What are the risks?

Despite being marketed as low risk investments, there are lots of risks to consider:

  1. Inflation. Tracker bonds have a very poor tracker record in clients getting a return on their money. They usually just get their money back. The purchasing power of their money has decreased over the investment period.
  2. Money Locked Away – You cannot access your money during the investment term. You must wait until the end of the investment term.
  3. Market Timing – The investment term ends at a specific date in the future. It is impossible to know if the markets on 22 June 2021 will be higher or lower than they are today. It is irrelevant if the market increases exponentially in the interim years. All that matters is the value on that closing date.

Tracker Bonds are incredibly complex investment instruments. There may be limits on how much you may make and how much of your money is guaranteed. If you do not fully understand them, do not invest in them.

…and remember, you cannot earn equity sized returns without taking equity sized risks.

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