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Add a TEP to your fixed-interest portfolio

By Neville Bennett

Friday 19th September 2003

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A traded endowment policy (TEP) could be a useful addition to the stable of fixed-interest products. It is another type of egg in a diversified basket of investments. It also produces a good yield of 6% tax-free, equivalent to 9.84% for taxpayers in the 39c in the dollar class.

It works rather like a zero-coupon bond, which is an investment where the investor pays a sum of capital upfront and after several years, on the maturity of the investment, collects the original sum invested plus accrued interest. It is a way of putting compound interest to work.

TEPs are available from the policy trading market, established in 1994 by the Life Insurance Policy Exchange.

TEPs are life insurance "with profits" policies that individuals have decided to cash in. Policy Exchange transfers the ownership to Guardian Trust and a weekly list of policies is then circulated. The policies have a guaranteed maturity value, but as they are "with profits," the investor may also receive a "terminal bonus" at maturity.

Fixed-interest investors are cautious and engage in risk-analysis. The first risk is capital risk: what chance is there of losing capital? This depends on the insurance companies involved. The exchange uses insurance companies that have a credit-rating of BBB or better. British and New Zealand life insurance icons have taken a battering recently as poor equity markets eroded their capital bases but that has been largely redeemed by a recent bull market recovery. The default risk seems low.

Another risk is return risk. Can the insurance companies generate sufficient returns to maintain their bonuses? This does not seem difficult as the product is locked in for a set time period, so the insurer can generate good returns by buying government bonds or similar sound stock.

There is a liquidity risk. What if investors changed their plans and wanted to cash in before maturity? They can either cash up with the insurance company or sell back to Policy Exchange.

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