Theoretically, there are at least two reasons for interest rates to be positive. First, the need to compensate creditors for postponing consumption i.e. the time value of money, and secondly, the need to compensate creditors for the varied but unavoidable risk of not being repaid i.e. credit risk.

In practice, since at least the earliest references to debt in the ancient world, the fact of debtors compensating creditors has been widely accepted. This continued through the classical period, and even in Medieval Europe where usury was forbidden by the Christian Church, interest-bearing loans were the norm.

But in the wake of the Lehman collapse in September 2008, the global economy and banking system faced meltdown. Many feared a re-run of the great depression. This view failed to reckon with the powerful tools available to policymakers. Crucially, the policy responses to the pandemic have seen these tools deployed with renewed and expanded aggression.

Negative official interest rates are the new normal in Europe and bond investors at every maturity out to 30 years are all but paying for the privilege of loaning money to many Eurozone governments. More generally, negative real long-term interest rates are now embedded globally.

ECB Official Interest Rate

Unsurprisingly, the resulting hunt for return has heightened the lure of financial markets. This recent quote from the Financial Times on the striking success of the financial trading platform Robinhood – one among many such services – captures the mood well:

‘Customers are flocking to the platform – Robinhood has become synonymous with the boom in retail investing that has drawn millions of people to the markets – many for the first time – to join the roaring rally that began in March and this week pushed the S&P 500 to an all-time high.’

Anecdotally, there is no doubt that many people here have also joined the fray. With Irish deposit rates going negative and deposit sizes going skyward, it seems timely to consider how such savings might be invested.

In a series of pieces starting today, I hope this beginners guide will be a helpful contribution.

Note: I will not be covering the seemingly perennial preference of the Irish investor – property – in this series.

Financial markets are helpfully seen as an asset risk spectrum stretching from risk-free assets to their riskier counterparts. Correspondingly, the return on offer stretches from the risk-free rate to the risk-free rate, plus or minus, the potential gain or loss from bearing risk.

The Asset Risk Spectrum

Bank Deposits: Traditionally, the risk-free asset in Ireland is a bank deposit generating a risk-free return in the form of deposit interest. Necessarily underwritten by the government and backed in practice by the ECB, the nominal value of bank deposits is effectively guaranteed.

Government Bonds: In like fashion, loaning money to the government via an Irish Government bond is also effectively risk-free. Again, underwritten by the government and backed by the ECB, there is little doubt that the interest and capital will be repaid in full and on time.

Corporate Bonds: Moving out the risk spectrum, the next asset is credit or loaning money to companies via a Company/Corporate bond. While credit markets are a huge part of the financial market landscape across the Atlantic, they are much less significant in Europe where banks are the main provider of corporate credit.

Importantly, the return is not risk-free. Loaning money to a corporation always entails the risk of loss. This is compensated for by the potential, but not the guarantee, of a higher return than the risk-free alternative.

Stocks: Company stocks, shares or equities come next. For the shareholder, they confer a proportionate ownership stake – reflecting the percentage of the shares owned – and a proportionate share of the profits generated.

Crucially, this is profit after the servicing of debt. In the capital structure of the firm, the shareholder ranks behind the creditor/bondholder. Fundamentally, this means that shareholders bear more risk than creditors, and, again, must be compensated by the potential, but not the guarantee, of a higher return.

Company Balance Sheet

Alternative Assets: In recent decades, there has been strong growth in so-called alternative assets. This is a heterogenous category which includes everything from private equity to commodities such as gold or oil. All such alternatives have a correspondingly varied risk and potential return profile and should be positioned on the asset risk spectrum accordingly.

Derivatives: For completeness, it’s important to mention derivatives. A derivative is a financial instrument whose value is derived from the value of another asset, which is known as the underlying. When the price of the underlying changes, the value of the derivative also changes. Simply put, a derivative is a contract that derives its value from changes in the price of the underlying. Importantly, this contract is often structured to give access to leverage which will clearly change the risk and potential return exposure.

Among much else, the legendary economist John Maynard Keynes is famous for his telling and memorable choice of words. Presciently for investors today, none are as apt as the following from his General Theory in 1936:

‘I see, therefore, the rentier aspect of capitalism as a transitional phase which will disappear when it has done its work…the euthanasia of the rentier, of the functionless investor…’

As foreseen by Keynes, the age of the ‘rentier’ is over, and the need for a sensible framework to face this challenge has arguably never been greater. Having begun with a brief overview of the asset risk spectrum and where individual assets are positioned on it, the next piece will consider them collectively through the prism of portfolio theory.