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Picture: 123RF
Picture: 123RF

With the rand in free fall and markets roiling, last week was the perfect opportunity to ask if there is still a role for cash in a portfolio.

If you are looking for stable real returns there is a strong argument to consider SA money market instruments, and specifically the underappreciated 12-month negotiable certificates of deposits (NCDs).

To illustrate this we constructed a simple strategy return series whereby an investor purchases a 12-month NCD, and one month later (when it is now an 11-month NCD) sells the 11-month NCD and purchases a new 12-month NCD.

While this strategy is probably somewhat impractical in terms of accurately capturing trading costs, it would be a fair reflection of the investment outcome of a portfolio that maintained a constant 11- to 12-month exposure to senior debt of the four largest SA banks.

We compare the return of this strategy since 2000 to the total return associated with SA cash deposits (Stefi call deposit total return index), SA fixed-rate bonds (FTSE/JSE all bond total return index), and equities (FTSE/JSE all share total return index).

The graph illustrates that equities delivered superior absolute and real returns, albeit at considerably higher volatility. Inflation through this period averaged 5.6%, rendering an equity real return of 8%, a bond real return of 4.4%, and a cash real return of 1.6%.

What is noteworthy is the incremental real return achievable from the money market, with our simple NCD investment strategy yielding a nominal return of 9% and exceeding inflation by a handsome 3.4% annually over the period.

Our strategy exceeds cash returns by almost 200 basis points  and the return is almost comparable with that associated with SA government bonds. Of more importance is the subdued volatility associated with this investment strategy, implying superior volatility-adjusted returns.

Why is this the case and where is the catch?

SA banks are paying a significant premium for stable funding, as various regulations and funding gap prescriptions force them to extend the tenor of their funding activities.

The second graph illustrates that the 12-month NCD maintained a positive margin over the three-month NCD. This excess margin also appears to be increasing rather than decreasing due to more onerous regulation. The average margin rose from 50 basis points in the early 2000s to 120 at implementation of the Basel regulations and the Covid-19 pandemic.

Interest rate theory says investors should be indifferent to investing in short (three-month) and longer (12-month) instruments if the expected reinvestment in a series of three-month instruments equilibrates the return achievable from a 12-month instrument. In assessing this indifference it becomes useful to an investor to compare the 12-month investment to implied three month investments that would result in such indifference.

An investor with a 12-month investment horizon who chooses to invest in three-month NCDs versus a 12-month NCD does so with the expectation that they will be able to reinvest the maturing three-month investment in three months’ time at 8.5%, and again reinvest in another quarter for three months at 8.9%, and finally reinvest in a further three months’ time for three months at 9.2%. This sequence of three-month investments would render the investor with the same return as investing now for 12 months at the known investment rate of 8.8% for the full period.

Another way of thinking about this is that the investor should only choose to invest in three-month NCDs as opposed to a 12-month NCD if they expect 100 basis points of rate hikes in three to six months’ time, a subsequent 40 basis points in additional hikes in six to nine months’ time, and 30 of additional rate hikes in six to 12 months’ time. That is, 170 basis points of cumulative tightening over the next year.

The rolling real returns achieved by investing in 12-month NCDs instead of cash (since 2000) are clearly superior. Not only has the 12-month NCD investment strategy delivered excess real return of 1.8% annualised on average relative to cash, but it has mitigated inferior real returns during periods of high inflation and/or low monetary policy rates.

It is important to recognise the value of a stable real return driver during times of market turmoil. We suggest considering a 12-month NCD investment strategy as part of your diversified portfolio.

• Pretorius is fixed income portfolio manager at Matrix Fund Managers.

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