By: Bryn Hatty, Chief Investment Officer, Stonehage Fleming South Africa
In South Africa, for the first time in decades, we might be heading to a world where cash and money market funds produce negative returns relative to inflation for a meaningful time period. We all know the only free lunch in financial markets is diversification. Parking investments in cash and money market funds over the past few years, if not free, certainly felt like a cheap lunch as these assets produced steady inflation beating returns while local equity markets produced anemic returns.
For the past five years, investors have moved to the ‘safety’ of cash and money market funds at a relatively low opportunity cost. However, the opportunity cost might become much higher, for several reasons.
Globally, interest rates have been low for some time, without the expectation of substantial increases for a good few years looking forward. In South Africa, on the back of aggressive policy action by the Monetary Policy Committee (MPC) last year, the benchmark repo rate has almost halved from 6.5% to 3.5%. With no pressure from global rates and a weak economy, low rates are probably here to stay for the next few years, directly impacting the interest rate that investors earn on their bank deposits and money market funds.
Over the last 12 months, bank deposits have increased substantially as investors looked for safety during market volatility earlier in the year, and in addition, banks were able to obtain cheap funding from the SARB. At the same time, the demand for loans from the private sector have fallen off significantly as corporates and individuals delay capital expenditure. As a result, banks have excess capital and are under no pressure to pay up for funding. In fact, at certain parts of the yield curve, banks can borrow at cheaper rates than the government, which is very rare. This puts additional downward pressure on the rates earned by investors on bank negotiable certificates of deposit (NCDs) – the primary instruments held by money market funds.
Although inflation is currently very low, it should start to pick up from these levels and, in order to assist our economy in its recovery from the current recession, the MPC may not react to rising inflation as quickly as in the past. Consequently, investors seeking inflation beating returns on their local income assets will need to take on a bit more risk and short-term volatility by investing in slightly longer dated government, bank and corporate paper.
Investors in fixed income instruments face two main risks, which generally increase as one tries to improve returns. The first is default risk, where the borrower does not pay the expected interest or capital back on your investment, and the second is duration risk, the impact of changes in market interest rates on fixed income instruments.
Default risk applies to any fixed income investment even bank deposits. Income funds have the ability to be far more diversified from a credit perspective, as they invest with many different counterparties in their portfolios as opposed to just one bank in the case of a deposit, or four or five banks in the case of a money market fund.
Interestingly, because of the fiscal issues facing South Africa, the current steep yield curve is essentially implying that it’s riskier to lend money to the government than it is to lend to an individual in the form of a home loan. A 10-year government bond currently yields around 9%, as opposed to 3% on cash in the bank. By taking on some risk in this space, investors could achieve a very healthy yield. Finally, it is important to remember that a government debt default would impact the whole financial system, including banks and potentially deposits – as most fixed income instruments are indirectly exposed to a sovereign default to some extent. This is why the credit rating of banks is linked to the credit rating of the country within which they operate.
Increased duration, the second risk that an investor can take on to potentially increase returns, is the impact on the value of your fixed income holdings resulting from changes in market interest rates. A 10-year bond with a duration of 8 years, for example, will reduce in value by 8% if interest rates go up by 1% and vice versa. Therefore, the longer the duration of your bond investment, the more sensitive it will be to changes in interest rates. Importantly however, if you hold it to maturity, and the bond issuer doesn’t default, you will still earn the original yield that you invested at. In a normal environment investors get compensated with a higher interest rate for investing in longer dated bonds, however, currently in South Africa this differential, between long and short-dated interest rates, is extremely high relative to the past. This means that in general, by being prepared to ride out the short-term impacts of interest rate moves, you can earn a better longer-term return on your fixed income investments.