With record low interest rates, whereto for investors?

Just over a year ago, South Africa’s repo rate – the rate at which the Reserve Bank lends money to our commercial banks – stood at 6.75%. At a record pace it tumbled to its current 3.5%, after the Reserve Bank stepped in swiftly with ‘easier money’ to mitigate the economic carnage caused by worldwide lockdowns.

While interest rates at a near 50-year low is cause for celebration among those with home loans or other debt, they pose a serious problem for investors with a large portion of their portfolio in interest-bearing assets. These are notably retirees and investors who cannot afford to take on much market risk at this stage of their lives – whether that is due to temporary unemployment, the possibility of emigration or a large capital outlay looming in the short term.

South African repo rate – %

source: tradingeconomics.com

Those with existing fixed deposits are not affected

Investors who locked in their interest rates in long-term fixed deposits should not be affected by 2020’s plunge in the repo rate. But those with money in short-term notice deposits, in bank savings accounts and money market funds will suddenly see their interest income being reduced. For those living off short-term investments, the reduction in interest income means greatly more pressure on an already tight monthly budget.

Why are cash rates down, but bonds and longer-term deposits offer great rates?

Investors who have been shopping around during lockdown for better interest rates, might have noticed an interesting phenomenon. Even though cash rates and the yields currently on offer from money market funds are not worth writing home about, yields on government and other bonds are currently very attractive. Yes, the yields from these two groups of investments have pulled in opposite directions. To understand this, investors need to understand that interest-bearing products operate in one of two markets: either the money market or the bond market.

The money market is where cash instruments are traded that mature (expire) within 12 months. The rates on money market instruments generally move in the same direction as the repo rate. There is little risk that inflation will shoot up within a few months and exceed the interest rate offered on these instruments. There is also not such a big risk that the banks issuing these instruments will not be able to repay the capital; information about a possible pending bank failure normally precedes the actual event by a few months. Because these risks are low, investors cannot expect much more than the prevailing repo rate from money market or cash-like instruments.

The bond market is generally for debt that matures (i.e. the capital amount needs to be paid back) after 12 months or longer. That would include government bonds and bonds issued by big corporates needing funding. Let’s explain by using an example that’s received a lot of attention lately: the RSA Retail Savings Bond. Despite the lower repo rate, this government bond offers a guaranteed fixed interest rate of 6% per year if investors commit their capital to the three-year fixed rate bond and 8% per year for the five-year fixed rate bond. That is more than double the current repo rate.

Why the big difference between the repo rate and five-year government bonds?

The reason for the big gap between the record-low repo rate and the rate on the five-year bond is mainly due to two reasons: the 1) inflation risk and 2) counterparty risk on longer-term bonds. Inflation has dropped to a low 3.2% currently, but with a weak rand and high levels of imports by SA, it could easily head in the opposite direction. Part of the gap is to compensate investors for the uncertainty of not knowing whether their investment will keep up with inflation over the next five year. As far as the second risk is concerned, although the SA government has never defaulted on debt before, counterparty risk significantly increased with the Moody’s downgrade to ‘junk’ earlier this year. With the growing pile of debt that government needs to repay to its various lenders, there is now an increased counterparty risk – also known as credit risk or default risk.

So, yes, the rates on longer-term bonds are attractive, but they need to be – to compensate investors for the higher risks associated with them compared to money market or cash instruments.

Where the ‘best’ rates are depends on your unique circumstances

One of the tested principles of financial planning is to allocate money in your portfolio to different types of assets depending on when you would most likely need that money. In the financial world it’s called asset-liability matching.

For money that you would need in case of emergency, it’s best to stick to funds that you can access with a few days’ notice and where you do not risk cashing in at a time when you could lose some of your capital. A notice deposit or a money market fund would suit this purpose and the best rate currently available on an SA notice deposit is 7% with 10 days’ notice once the money’s been in the account for more than 90 days. An earlier withdrawal is possible, but it would be at a reduced interest rate of only 4%. For money market funds, the current yields are currently around 5%.

For money that you would need within the next one to five years, you can afford to take on a little bit more risk with the potential to earn a higher return than with your emergency fund. We mentioned earlier the RSA Retail Savings Bond as an example of a higher-return product, but one with risks. Investing in a fixed-term fixed-rate deposit with an SA bank can give an even higher interest rate than that offered by the government, but that’s because it’s riskier. Remember, it’s normally central banks that bail out commercial banks when they’re in trouble, not the other way around. The weakness of both government bonds and bank deposits is that you are heavily exposed to one counterparty, either the government or the commercial bank. If you choose one of these, your interest-bearing portfolio lacks diversification. Plus, you are locked in for either two, three or five years. Your investment therefore also lacks accessibility – also known as liquidity.

For a commitment of one year or more, fixed income funds tick all the boxes

One of the greatest value that interest-bearing unit trust funds add is diversification – they spread the fund’s assets widely across various government and corporate bonds and bank instruments. At present returns are looking quite attractive as well. Investors with between one and three years left before they will need their capital may want to consider interest-bearing unit trusts too. Your money will typically be invested in a combination of the bond and money market and the value of your investment will vary from day to day along with the market value of the underlying assets. What they lack in terms of a guaranteed rate, interest-bearing unit trusts make up for by including variable rate instruments, such as inflation-linked bonds. This means that investors will have a better chance of keeping up with inflation over the coming years, even if inflation spikes up.