FMA Focus Bonds vs Savings Books
Bonds vs. Savings Books - or: why is investing in bonds and structured bonds associated with other risks than depositing money into a savings book account (Show content for: Bonds vs. Savings Books - or: why is investing in bonds and structured bonds associated with other risks than depositing money into a savings book account)
The interest paid on money held in savings books are currently very low. When looking for higher interest rates, investors time and time again come across other offers like securitised (structured) liabilities, for example bonds or certificates. Such instruments are issued both by banks as well as by other issuers, such an industrial companies. Banks, insurance companies and investment firms are subject to comprehensive and ongoing supervision by the FMA, whereas other issuing companies are not supervised by the FMA due to there being no legal competence.
Aren’t bonds and savings books comparable alternative forms of investment to one another?
This page intends to explain to what extent the financial difficulties of issuers of bonds (including credit institutions) as a result of the potential linked consequences (bailing-in of creditors, insolvency) may conceal a risk for an investor, and how investing in bonds could therefore be more risky than depositing funds into a savings book.
Bonds in particular differ from savings deposits in that savings deposits held at Austrian banks are backed by the Austrian deposit guarantee scheme. The deposit guarantee scheme applies to deposits and credit balances including interest held in accounts and savings books, e.g. in current accounts, salary accounts and pension accounts, term deposit accounts and building savings contracts up to a value of EUR 100 000 per credit institution and per verified depositor.
There is no deposit guarantee scheme for bonds. When purchasing bonds, it is therefore particularly important that you are aware of and understand the risks that are associated with your investment.
By purchasing a bond, you become the creditor of the company that issues the bond. A company issuing a bond with precisely determined conditions raises money from investors. In return, as a rule, you as the investor receive interest. The amount of the interest is primarily based on the credit quality of the obligor, i.e. the company that issues the bond. The amount of interest should therefore be commensurate to the level of risk that is inherent to the bond. This principle otherwise applies for all financial products and investment opportunities.
Generally it applies that: the higher the prospects for returns are, the higher the entailed risk is! Higher interest rates mean a higher risk!
Bonds may be issued by banks or other issuers, e.g. industrial companies. Banks belong to the entities that are supervised by the FMA. In the case of other issuing companies, like industrial companies, this is often only applicable to a certain restricted extent (e.g. within the scope of prospectus supervision).
In the case of bonds issued by banks and other issuers the following general risks exist (note: it is not possible to produce an exhaustive list, as every product is designed differently, and therefore may be exposed to different risks).
- Exchange rate and interest rate risk: During the term of the bond, the price of the bond may go down as well as up, and may be subject to substantial fluctuations. Selling prior to the agreed maturity of the term may lead to deductions or may not even be possible due to the bond not being traded.
- Fixed income risk: The fixed income risk describes the risk of only being able to sell a fixed-income bond at a discounted price. This is principally the case when the fixed-rate interest are lower for the bond Held than the current market interest rates.
- Currency/exchange rate risk: For bonds the risk of exchange rate fluctuations also exist, in the case that a bond is not issued or repaid in Euro, but in another currency, for example in Swiss Francs.
- Liquidity risk: the liquidity of the bond describes its tradability. A risk exists that bonds are not able to be sold, or at least not at the desired price or during the desired time horizon. Depending on the design of the bond, your capital is often tied up until maturity and frequently may not be surrendered earlier.
- Insolvency risk: the insolvency risk describes the danger that the obligor, i.e. the entity that issues the bonds, becomes unable to pay. In this instance, you may lose your investment, either partially or in full.
In the case of a bank bond, there is also the risk of creditors being bailed in (“bail-in”). This is the risk, in the event of the bank entering resolution, of having to participate in the losses as a creditor of this bank. The resolution authority, which in the case of Austria is the FMA, may fully or partially write down eligible liabilities of the bank or convert them into instruments of ownership of the bank (e.g. shares), in order to stabilise the bank.
What does the term “bail-in” mean? How is a “bail-in” applied?
“Bail-in” is a potential measure that can be taken in resolution (“a resolution tool”) and means the participation of creditors of a bank in its losses. Investors that invest in bonds issued by a bank, become creditors of the bank. This means that in the case of a bank being placed in resolution, that such investors may participate in its losses, and therefore may possibly not get some or all of their invested capital back. The risk of a (total) loss also exists in the case of an insolvency of an entity. In this context there is also an important principle that is significant, that is not allowed to be breached in the resolution of a bank: no creditor of the bank is allowed to be treated worse on a financial basis than would be the case in the event of insolvency proceedings (“no creditor worse off”).
Why does the bailing-in of creditors (“bail-in”) exist?
As a reaction to the Financial Crisis, and the ensuring “bank bail-outs” by the state and/or the taxpayer, rules were issued (Directive 2014/59/EU “BRRD”, transposed by the Bank Recovery and Resolution Act (“BaSAG”) and Regulation (EU) No. 806/2014 (“SRM-R”) to allow the orderly resolution of banks. This was intended to guarantee that no more taxpayers’ money would need to be used for such bail-outs in the future.
When could I be affected by a “bail-in” as an investor (such as a bondholder) in the event of resolution?
You could be affected, if you are the shareholder or creditor of a bank. This is the case for example, if you hold financial instruments issued by the bank (e.g. bonds, certificates or shares) or have non-eligible deposits as part of a credit balance at the bank.
Whether you are affected in the specific case of a resolution involving the use of the bail-in resolution tool (“bail-in”) depends on the extent of this measure in the resolution as well as the classification of the financial instrument that you hold. In the event of creditors being bailed in, creditors are bailed in based on a prescribed order (“loss absorption cascade”) and the losses are allocated evenly across the eligible liabilities of the same rank. The following class is only called upon, where the claims of the preceding class are not sufficient for the absorption of the loss. Initially the capital instruments (such as the shares held by shareholders) are written down. If this capital is not sufficient to equalise the losses, then subsequently the bail-in calls upon the holders of relevant capital instruments and then the creditors of eligible liabilities of the bank to absorb the loss.
Are my deposits secured in the event of a resolution?
All deposits and credit balances including interest held in accounts and savings books at Austrian banks, e.g. in current accounts, salary accounts and pension accounts, term deposit accounts and building savings contracts are secured by the deposit guarante system in Austria. The level of deposit protection coverage is EUR 100 000 per credit institution and per depositor, whose identity has been verified.
Deposits under the definition of the statutory deposit guarantee scheme are explicitly excluded from the resolution tool of bail-in, and do not participate in the bank’s loss absorption in the event of resolution.
Are other financial instruments (e.g. securities, bonds) in my securities account also affected by a bail-in?
The financial instruments that you hold in your securities account at a bank under resolution, but which were not however issued by this bank, are not affected by any application of the bail-in resolution tool. In the event of a resolution, your ownership of such financial instruments remains intact.
Must my advisor/the entity inform me about the “bail-in-ability” of a product?
An advisor must act honestly, fairly and professionally in accordance with the best interests of his client. The advisor must provide you with up-to-date, complete and comprehensible information, as well as also informing you about the potential risk entailed in relation to the application of the bail-in resolution tool. Major changes in relation to relevant information about
the entity and its services,
- the financial instruments,
- the protection of financial instruments held by clients and clients’ funds and
- fees and ancillary costs
should be communicated to you promptly.
Entities offering their own financial instruments or financial instruments issued by another entity within the group, that are “bail-inable”, must make additional information available to you. This information must explain the differences of the financial instrument with regard to return, risk, liquidity and the level of protection compared with deposits at a bank.
Existing customers that hold “bail-inable” financial instruments should also receive comprehensive and as applicable updated information. This may for example be in the form of a periodical report or through the entity’s website.
Structured bonds, which for example include certificates, are debt securities of a single issuer, with the repayment or payment of interest being in accordance with the development in value of a underlying item. This “underlying” may for example be a share or an index. You also become a creditor of the issuing entity in the case of structured bonds.
The development in value depends on lots of different parameters, that additionally may also influence one another. In this way several risk may materialise at the same time. In this regard, reference is made to the list of risks contained in the previous section. An additional risk that exists in the case of structures bonds is the price risk of the underlying. This means the risk that the price of the underlying develops in an unfavourable direction for the investor, and the investor sustains losses.
There are many options how to design a structured bond. It is therefore particularly necessary to check the properties and risks of every structured bond. For further information please also visit The Basics: the Financial Market.