By Santhiran Naidoo, 4 April 2014
The repo is used as the benchmark interest rate from which other local interest rates and yields on interest bearing securities are derived. The SARB justified the largely unexpected decision by citing concerns surrounding local currency weakness as well the burgeoning upside risk to inflation. The reason many economists ruled out an early restrictive interest rate hike is that growth forecasts for South Africa continue to be subdued.
Interest rate changes by the SARB and changes in the expectations for future interest rates tend to directly impact more conservatively invested individuals (retirees as an example) since these individuals tend to have portfolio allocations skewed towards low risk interest bearing investments. While the effect of rising interest rates is felt across all asset classes, it is of particular importance in the retirement space where the repo is the interest rate underpinning the local fixed income market.
Exploring the interest rate expectations of the market as well as understanding the mandate of your portfolio and the outlook of your portfolio manager are important factors when looking at your interest bearing investments.
With five more Monetary Policy Committee meetings scheduled for the year, portfolio manager expectations relating to interest rate decisions by the SARB will play a significant role in how they position their various interest bearing portfolios over the coming months.
South African Forward Rate Agreement (FRA) Curve (%) – 11 March 2014
Source: I-Net Bridge and Glacier Research
The Forward Rate Agreement (FRA) curve depicts the market expectations of short-term interest rates in the future. Without delving into the derivative structures underpinning the FRA curve, one could simply interpret the curve as depicting investor expectations of SARB monetary policy. It indicates the three month rate an investor could “lock in” at a specific point in the future by utilising derivative contracts. Looking at the blue line labelled “Today” and the point 5*8, investor expectations are for the annualised three month return (starting five months from today and ending eight months from today) to be 6.62%. The red and yellow lines depict expectations from six months and one year ago.
An upward sloping curve would indicate that the market is anticipating short-term interest rates to increase while a downward sloping curve would imply that short-term rates are expected to decline. Looking at the curve above it is evident that the market is pricing in expectations of significant tightening in monetary policy over the next 18 months. The expectation is for the annualised 18*21, three month (starting 18 months from today and ending 21 months from today) return to be 7.97%. This represents a significant rise in short-term rates from the current repo rate of 5.50%.
It is also worth noting that the FRA curve looks significantly different today from what it did one year ago when the expectation was that interest rates would remain flat for an extended period of time.
South African Yield Curve (%) – 11 March 2014
Further evidence of expectations that we are moving into a rising interest environment can be seen in the yield curve where the short end shows significant steepening compared to six months and one year ago.
While many managers believe that the rate hiking decisions priced into the FRA curve are too aggressive, there is a general consensus that South Africa is now moving into a rising interest rate environment; even if the timing of these rate hikes is uncertain.
Changing interest rates and changing interest rate expectations impact the performance of portfolios. It is thus vitally important to understand what the portfolio manager’s interest rate expectations are when looking at the positioning of their portfolio. As with many other asset classes, interest bearing instruments are also prone to having too much negativity or positivity priced in at certain times. An astute manager with conviction in his interest rate view will take advantage of opportunities the market presents.
Fixed rate instruments price in the expectations of the market and provide a fixed defined return over a pre-defined period of time. The return on floating rate instruments, on the other hand, will vary as interest rates change. Having a different view to the market thus allows the manager to take advantage of these perceived “mispriced” opportunities. As an example, if the manager believes the FRA curve is too aggressively priced, he could opt instead for a fixed rate instrument (rather than a floating rate instrument) which accounts for this aggressive hiking expectation that the market is pricing in. If the manager’s view turns out to be correct and interest rates rise at a pace slower than the market had anticipated, he benefits from receiving a higher fixed rate which initially priced in a more aggressive hiking cycle. Various other scenarios could emerge where a skilled manager could exploit deemed inefficiencies in the interest bearing market.
Interest bearing portfolio managers are also limited by their specific mandates. The Association of Savings and Investment South Africa (ASISA) has grouped interest bearing funds according to their maximum duration limits. The duration of an instrument or fund represents the interest rate risk of the fund. A higher duration represents a higher interest rate risk. Instruments or funds with a higher duration will experience greater capital losses when interest rates rise. The opposite holds true for instruments or funds with a lower duration.
A summary of the ASISA local interest bearing focused categories is as follows:
Rolling one year category average returns (one month shift) (%) vs. the SARB Repo Rate (%)
Source: Morningstar Direct and Glacier Research
In the more flexible categories like the SA – Interest-Bearing - Variable Term and SA - Multi Asset - Income, managers have more discretion to manage duration without constraints. The portfolio manager could add or remove duration to the portfolio depending on his views on the path of interest rates. The graph above shows that the Variable Term category is significantly more volatile than the Multi Asset - Income category despite both being unconstrained in terms of duration. Volatility refers to the variability of returns. Looking at the graph above we can see that the Variable Term category average rolling one year return differs significantly at various points in time (more so than the Multi Asset - Income category). Understanding the structure of funds in these categories helps to explain the difference in volatility.
The key difference between funds in these two categories is the SA – Interest-Bearing - Variable Term funds are generally benchmarked against the higher duration All Bond Index (ALBI) and thus fund performance is usually judged relative to the ALBI. These funds invest solely in interest-bearing securities and may hug the benchmark (not taking large active bets relative to the benchmark) resulting in a risk profile similar to the high duration ALBI (the latest duration of the ALBI is 6.13) – see graph below.
Rolling one year returns (one month shift): SA – Interest-Bearing - Variable Term Category Average (%) vs. ALBI (%)
On the other hand, funds in the SA - Multi Asset - Income category usually have a more absolute focus, focusing on earning returns above either cash or inflation and are able to more actively exploit mispriced opportunities by adding or removing duration relative to the ALBI. In addition, these funds are also able to include other asset classes into the portfolio. Including other asset classes allows managers to diversify risk and lower the volatility of returns. The ability to include other asset classes tends to produce a smoother return profile (without extreme highs and lows) which more conservative retiree investors prefer as they are generally uncomfortable with extreme volatility.
As the industry has evolved, education around personal risk profiling and diversification has advanced. This has seen retirees start to shift their exposure from low duration interest-bearing funds in the Money Market and Short-Term categories into more diversified portfolios such as those in the Multi Asset - Income category – generally providing conservative investors with a higher yield but without the high volatility of the Variable Term category.
As we move into what many believe will be a period of rising interest rates, it is important that investors, especially more conservative retirees, understand the ASISA categories which different funds fall into, the individual fund mandates as well as how the portfolio manager’s view will influence the overall risk and performance of their interest bearing funds. Funds in the Money Market and Short-Term categories should expect to benefit from a rising rate environment. The effect on funds in the Variable Term and Multi Asset - Income categories is less certain and will depend on the portfolio manager’s ability to manage interest rate risk and use their views to exploit opportunities that the market presents. Despite conservative investing being traditionally seen as centred in the Money Market and Short-Term categories, the option to utilise funds in the more diversified and absolute return focussed Multi Asset - Income category should be considered.