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Should money market investors be afraid of a downgrade?

Reader’s questions answered.

CAPE TOWN In this advice column Robin Gibson from Harvard House answers a question from a reader who is concerned about the effects of a credit downgrade on her savings.

Q: My husband and I are retired. Our pensions are adequate to cover our monthly expenses, but we have a substantial amount of money invested in a major financial institution.

With all the discussion around a credit downgrade, we are concerned about the money markets and how this would affect our investments.

Because of the above, and our advanced age, we would like to know whether we should rather take the money out and invest some in short term fixed deposits in the bank. We are aware of the tax implications.

The writer does not say whether she and her husband are invested ‘on the balance sheet’ of an institution through a money market bank account, or if their money is held in a money market fund collective investment scheme (unit trust). The difference is very subtle but can have a substantial impact on the end result.

When an investor purchases a money market unit trust then the underlying instruments are made up of money market instruments issued by a number of different institutions. The objective of these funds is to enhance their yield by purchasing a number of different instruments, some with higher risk that offer better return and others that offer less return but lower risk.

Generally these funds are considered safe, but there have been historic examples that show how unforeseen calamities can have a negative effect on them. Most recently the collapse of African Bank resulted in many of these funds suffering losses. This was a reminder that there are risks involved in the underlying instruments.

The alternative is to be invested directly with a banking institution, where you become an ‘on balance sheet’ liability. This then means your risk becomes easier to assess, as the risk lies only with the stability of the bank you have chosen. The downside is that the better the institution, the lower the interest they will pay you. 

A good historic example might be Saambou versus Standard Bank. The former is no longer with us, while the latter has weathered a number of difficult storms.

The South African Reserve Bank released its Financial Stability Review recently which assesses, among other things, whether the financial system is resilient to systemic shocks. This would include a sovereign rating downgrade.

Part of this report commented on ‘stress testing’ performed on the local banks, which looks at what would happen in different scenarios. It concluded that even in adverse scenario testing our banks look strong. The report said that: “Participating banks are therefore regarded as adequately capitalised to withstand significant credit losses throughout the stress scenarios before taking into account any mitigating action by banks’ management”.

This suggests that the major banks are of little concern.

We would therefore say that a downgrade would have little direct effect on investors in the money market. If anything, the yields would go up.

Remember that South Africa only reached investment grade status in the late 1990s. Being below investment grade is therefore not something unprecedented.

The only benefit we could see to moving your money into a short term fixed deposit would be to obtain the same yield for less risk than in a money market unit trust. In life anything is possible, but we do not see that a South African ratings downgrade should require you to take such action.

Robin Gibson CFP ® is a director of Harvard House Investment Management in Howick.

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Another funny Investec view that methinks is missing the point again, as reported in Fin 24 today:

”The country has a relatively small pool of dollar bonds, compared with rand-denominated debt, and a large domestic money management business with the capacity to invest in the assets, Du Toit said in an interview on Wednesday at the World Economic Forum on Africa in Kigali, Rwanda’s capital”

There would be a several ways that investors would be impacted by a downgrade, despite the view that management business will have a large domestic money market to invest in, as :

• current bond investors would experience losses
• investors in the equity markets will receive lower returns
• disposable income of the locals will be eroded by higher inflation and taxes
• SA Government bonds would rise as investors would demand higher interest rates to compensate for higher risk/reward levels , hence the Governments cost of borrowing will rise
• there will therefore be a fall in capital values
• higher borrowing costs would force the government to raise more revenue via higher taxes thereby taxpayers could end up with much lower disposable income to save and invest
• The Global markets will immediately be excluded from global government bond indices and current and potential investors would be excluded from investing in South African non-invest grade assets (like most large offshore pension funds), which would pressure yield to rise
• this reduced foreign demand for SA bonds will result in money to leave SA which would result in further rand weakness and eventually impacting inflation and investors returns
• Corporate balance sheets ( and state-owned enterprises) of private companies will be effected by the increase in cost of borrowing , impacting negatively on profits, investor dividends and returns on equity investments
• Fewer corporate bond issues in a much smaller market would result in fewer high-yielding investment options for local asset managers
• although SA only reached investment grade in the late 1990’s a wall of money fell into South Africa (especially under Mandela’s guard) , and SA also became the top emerging market destination for a plethora of offshore investors
• junk status will result in gloom and doom for the ones that ”can least afford it”‘

if I may, you omitted to note that by definition, all locally rated entities (ie banks and SoEs mainly) will also be downgraded. This will impact their ability to raise debt and the cost of that debt and in many cases could trigger collateral obligations under existing arrangements …. resulting in a liquidity squeeze and cost of funding.

I have also seen comments by our alleged “clever economists” and I don’t understand where they get their information.

maybe that’s another concern for the list …. our economic commentariat are clueless.

Many thanks Bertie, all agreed !

I do have a lot of well known economist friends (mostly ex-colleagues etc) that I respect in lots of ways, but I have also experienced over time that most of them are re-active and not pro-active pertaining to anything out of the ordinary in the financial markets.

My view is that they become ”information junkies” and tend to follow the ”popular views”as this is paying their fees and wages on an ongoing basis.

I always watch the annual Network 24 (Beeld etc) reviews and forecasts from economists in the beginning of each year and almost always find that most of them ”missed the boat” altogether.

yeah, given that the ANC regularly haul banks in to tell them to lend more money to muni’s to prove “their commitment to the new South Africa”, I have no doubt they also get hauled in when their research guys release negative views.

its a point that Magnus Heystuck is completely correct on – there is little to no independent economic analysis in SA.

Invest your cash in New Gold ETF. This is less volatile than pure USD since the price of the ETF is impacted by both USD/ZAR exchange rates and USD/Gold price.
This will buffer you against the impact of a sudden ZAR drop.

thanks folks … that’s your daily message from ABSA marketing department

*shakes head
**small wonder Barclays are dumping that building society

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