What is the better choice: investing your money in a 30-day notice bank account (such as the African Bank notice deposit, which offers 10.5%) versus investing in unit trust income funds? Do you have any recommendations on the comparison and/or the funds and bank providers?
South Africans are currently finding themselves in a high interest rate environment (compared with internationally), together with low inflation locally. Real returns from cash and fixed-interest instruments are therefore for the moment attractive, considering a negative double-digit return from risk assets for the year to date.
Cash and fixed-interest instruments returns (such as local bonds) have been quite impressive in US dollar terms, considering the strengthening of the rand since November/December 2015. As both of these asset classes outperformed local equities and listed property, it is necessary to refocus on the appropriateness of each asset class, instead of just the short-term return results.
Cash and cash-equivalents are perhaps better understood by investors than ‘income funds’. Income funds consist of cash, cash-equivalents, listed/unlisted bonds (such as short-dated government bonds and corporate/inflation-linked bonds) and possibly small exposures to listed property/equity. Income funds predominantly have local assets but can include offshore assets of the same categories, typically 10% to 30% (within Regulation 28).
Although these funds are low risk, they can be more volatile than cash during liquidity crunches in the bond, property and equity markets. Income funds can appreciate in value from the reinvestment of interest, rent and dividends received, but also from an instrument pricing point of view. The price of bonds is driven by factors such as changing interest rates and liquidity considerations (normal supply and demand mechanisms).
Considerations for choosing an appropriate asset class
- Investment term
Considered individually, cash and fixed-interest instruments – together with low exposures to listed property/equity (income funds) – are well suited for a short-term investment period of one to three years. Cash and income funds form part of a diversified portfolio, but considered individually, they are both effective for ‘capital preservation’ strategies.
- Risk or certainty
Bank notice deposit: Investors should be rewarded with above-inflation returns for taking on investment risk. I see a cash investment as a preservation/parking/payment tool, where a client has no market risk appetite. Each bank has a credit rating, which is an indication of the bank’s ability to repay its depositors. Standard Bank, Investec, FirstRand, Absa and Nedbank, for example, all have a Moody’s rating of Baa3. The credit rating of each bank should be factored in when interest rates are considered in a like-for-like comparison, as not all banks are the same.
Income fund: Investors investing in income funds must acknowledge that income funds can drop by 5% to 15% during short-term extreme volatility. A key focus for income fund management is to avoid permanent loss of capital at all costs.
Bank notice deposits: In South Africa we have seen a few examples of banks that got into financial trouble. Although this is a highly unlikely event, it should still be part of your consideration, especially if you place all your savings (retirement/discretionary) with one depository.
Ideally, do not place more that 20% of your life savings in one financial instrument.
One can see that a pure return consideration (such as the additional 0.05% to 0.2% per year return from Bank A versus Bank B) pales in insignificance if there is a risk of losing your investment capital plus interest.
Income fund: Income funds are a well-diversified but conservative investment strategy. A combination of income funds run by respected asset managers are in my view one of the safest forms of investment other than cash.
Bank notice deposits: As the name indicates, notice deposits have a notice period attached to them. The shorter the notice period (more liquid), the more the investor compromises on the return expectation. Interest returns are taxed at the marginal income tax rates of each individual investor, with a maximum marginal tax rate of 45% once exemptions are exhausted.
Income fund: Income funds are fully liquid and take around three to five days to liquidate to cash. Bonds, listed property and equity (depending the item) can hold some short-term liquidity challenges. Permanent capital loss is possible if debt issuers/companies go into liquidation. Interest and dividends can be either reinvested into the fund or paid to investors.
Interest returns are taxed at the marginal income tax rates of each individual investor to a maximum of 45%. Dividends from property/equity holdings have a 20% dividend withholding tax at source (less than half the maximum 45% personal marginal income tax rates).
Bank notice deposit: Below are the actual fixed and notice deposit interest offerings I found on African Bank’s website as at December 10, 2018.
Fixed deposit rates
Notice deposit rates
‘Interest payout on expiry’ means interest is reinvested and only paid out after the expiry date of three, six, 12, 24 or 60 months.
The African Bank offering from notice deposits leaves very little room for a real return (considering inflation of around 6% versus the net-of-tax interest returns to investors).
Income funds have a return combination of all the below asset classes. These returns (all higher than cash over the medium to long-term) result in a handsome outperformance of cash over time.
For me, the greatest benefit of income funds is the predictable low risk, low-volatility profile of the instrument, with full liquidity and outperformance of cash over the medium to long-term. Considering that we have entered a rising interest rate environment, the differences between cash and income fund returns might be smaller than historically.
Stick to reputable asset managers in the income fund environment to help avoid permanent loss of capital.
The information in this document is provided as general information. It does not constitute financial, tax, legal or investment advice and the PSG Konsult Group of Companies does not guarantee its suitability or potential value. Since individual needs and risk profiles differ, we suggest you consult your qualified financial adviser if needed. PSG Wealth Financial Planning (Pty) Ltd is an authorised Financial Services Provider. FSP 728