The Individual Savings Account, or ISA, has now been running for almost 20 years and over that time has established itself as one of the most popular products for individual investors. At the end of the 2017 the total market value of Cash and Stocks & Shares ISAs stood at a whopping £585 billion, with 12.7 million accounts being subscribed to during the year.
By Andrew Adcock of Crowd for Angels
Investors have been attracted to the government steadily increasing the annual allowance over the past few years and of course the tax free benefits which ISAs bring.
But despite the ISA’s tax free benefits, decent returns are becoming increasingly hard to come by.
On the Cash ISA side, interest rates on offer right now are near all time lows, with personal finance website Moneyfacts finding that the average easy access Cash ISA rate was just 0.62%. In Stocks & Shares, many major financial indices around the world are currently at or near all time highs, with a number of financial commentators suggesting that equities are over-valued and due for a downward correction.
Then we have to combine this with the creeping march of inflation. Over the past two years the CPI measure of inflation in the UK has risen from just 0.3% to 2.4% (May 2018). This means that Cash ISA investors are seeing a negative real return on their savings, with equity investors having to look for increasingly risky investments in order to maintain their purchasing power.
But flexibility over ISA allocations, combined with a new ISA rules, mean that there are other ways of making a decent real rate of return
For the 2016/2017 tax year the government increased the annual ISA allowance to a generous £20,000. In addition, in 2016 a new product was added to the ISA stable – the Innovative Finance ISA (aka the IFISA). This allows investors to earn a tax-free return on loans issued by P2P lenders and so called “crowd bonds” issued by crowdfunding companies. Interest rates on these financial assets currently on the market, which are typically in the form of business loans, start at around the 4% level but can be as high as 12%, dependent on risk. That’s an attractive rate of return in the context of the Cash ISA and is within the range of historic expected returns on equities.
To give one example of a crowd bond, car finance business, The Asset Exchange, is currently looking for investors through Crowd for Angels. The company is seeking up to £300,000 by issuing a crowd bond and in return is offering interest of 12% p.a., paid monthly, fixed for 18 months. The minimum investment is £100.
Crucially, enabling investors to manage risk and return, the increased ISA allowance can be split in any proportion between the Cash, Stocks & Shares and IFISAs. For example, an investor with a higher risk tolerance might want to put £7,500 in a Stocks & Shares ISA, £7,500 in an IFISA and £5,000 in a Cash ISA. This means that, working with assumed rates of return for the different products, an investor can effectively set their own levels of risk and return.
Using the Cash and IFISAs only to simplify the calculations, here are a few examples.
Investor A – No tolerance for risk
Investor A is mainly concerned about preserving his capital so puts all of his ISA allowance Into a Cash ISA. This is effectively a risk free deposit so earns a low rate of interest – National Savings & Investments (NSI) is currently offering a 0.75%, no notice Cash ISA. While the investor has no risk of losing his capital he is earning a negative real rate of return given that inflation is at 3%.
Investor B – Low tolerance for risk
Investor B is prepared to take on a little more risk to boost his returns. He might do this by putting three-quarters of his annual ISA allowance into cash and the rest into a 12% IFISA eligible crowd bond. This boosts annual returns up to a more attractive 3.56%, a figure which is ahead of current levels of inflation.
Investor C – Medium tolerance for risk
Taking on more risk, Investor C splits their annual ISA allowance equally between cash and the IFISA bond. This takes annual returns up to 6.375%.
Investor D – High tolerance for risk
Finally, investor D has a high risk tolerance and puts three-quarters of his allowance in the IFISA eligible bond and the rest in the Cash ISA. The effective interest rate now rises to 9.19%, a level approaching that of expected returns from equities, with the 25% Cash ISA allocation providing a risk free buffer.
The chart below shows the rising levels of interest investors can obtain by increasing their exposure towards IFISA eligible bonds and away from cash.
Of course, like with any investment, the increased returns are possible because investors are taking on additional risk.
Lending money to businesses in the form of loans or bonds puts investors at risk of the company not paying back the capital or interest which it owes. So in other words, some or all of investors’ capital is at risk by investing in IFISA eligible bonds. And unlike with the Cash ISA, there is no Financial Services Compensation Scheme to fall back on should the product provider (P2P/crowdfunding platform) go into default. However, some crowd bonds, such as those issued by Crowd for Angels, are secured against assets of the lending company, thus reducing the risk of lending.
Andrew Adcock is Chief Marketing Officer at Crowd for Angels, an FCA regulated crowdfunding platform which is approved by HMRC to operate the Innovative Finance ISA and offers a range of crowd bonds to investors. For more information visit http://www.crowdforangels.com