Losing Interest in Interest?

Should you stick with the money market fund? Should you look for higher interest rates elsewhere? With interest rates having come down, is it time to buy shares instead?

These are some of the questions we try to answer in this week's article. In order to stimulate the economy – battered by COVID-19, amongst other things – the South African Reserve Bank (SARB) has lowered interest rates.

The repo rate (the rate at which commercial banks borrow from the SARB) has dropped three times this year: first by a quarter of a percent in January, then by a full percent in March and another full percent in April. This has taken the repo rate from 6.5% at the end of last year to 4.25% today, the lowest rate in over 20 years.

Importantly, further interest rate cuts are not unlikely.

Changes in the repo affect all of us because the interest rates at which banks lend and borrow move up and down with the repo rate.

The prime rate, for example, is the interest rate used by commercial banks as a starting point for loans. The prime rate has followed the repo rate down, dropping from 10% at the end of 2019 to 7.75% today. Home loans are often quoted in relation to prime. Someone with a good job buying a flat might be offered "prime plus 1%" meaning a rate of 8.75% per annum on the loan at today's rates.

The interest rate at which banks are borrowing short-term money is known as the call rate (because the depositor can "call" on the cash, or take it back, at any time). Call rates are a good indication of the sort of interest you can earn in a savings account on larger deposits (say, above R50,000). Like the prime rate, the call rate has followed the repo rate down. Call rates are now around 3.75%.

The gap between the interest rates that banks charge their customers (eg, prime) and the interest they pay on deposits (eg, call rates) fluctuates depending on various factors like money supply and demand for credit.

Sometimes the gap is quite narrow. In 2008, for example, the prime rate climbed to 15.5% and call rates went up to almost 12%, meaning call rates were three-quarters of prime. At other times the gap is large. By 2013, for example, prime had fallen to 8.5% but call rates had dropped to 4.5%, making calls rates only just over half of prime.

Right now the gap is about as big as it ever gets – call rates are slightly less than half of the prime rate.

With the above as background, we can return to our questions.

Should you stick with the money market fund?

If you're fully or mainly invested in risk-free interest-bearing products, this could be for any one of the following reasons (amongst others):

1. You're risk-averse and have always avoided equities

2. You're saving for a short-term goal or you're still building your emergency fund

3. You were waiting for the right time to switch into equities… and you're still waiting

If you're in the first two categories, you certainly need to stick with risk-free options.

If you're in the third category, you have three main choices – switch now, switch some now and some later, or keep waiting and switch later.

Before talking about equities, though, let's consider what's in store for interest rates.

The yield on the Allan Gray Money Market Fund has held up surprisingly well so far. The gross rate of 6.92% is still close to 7% in spite of the cuts in the repo rate.

When the repo rate was 7.0% in 2016, gross interest on the Allan Gray Money Market Fund averaged 7.5%, so interest of nearly 7% when the repo rate is at 3.75% is very good, especially considering the current gap between prime and call rates.

However, money market rates are likely to trend downwards for the foreseeable future.

For the meantime, the real rate of return for cash investors is still positive (ie, beating inflation). The annual inflation rate fell to 3.6% in December 2019. Although it rose to 4.6% in March, it is expected to fall back to 4% or lower over the next few months.

Are there better interest-rate options than the Allan Gray Money Market Fund?

Yes and no. You can earn higher interest if you (1) lock up your cash for one to five years, or (2) take on some risk. In other words, higher interest rates are available in the fixed deposit market and in the bond market, but there are strings attached.

For example, the Allan Gray Bond Fund currently has a running yield of over 10%. The catch is that, like equity funds, bond funds are subject to price fluctuations. So there is a risk of capital loss. Clearly, it's no good earning 10% interest if you lose 10% of your capital because bond prices drift lower.

You can get higher interest rates for the next year or two in fixed deposit investments. However, that cash is then not available to you for the period you select. (Some fixed deposits allow partial withdrawals, but that usually triggers an interest penalty, which then defeats the object.)

So although interest rates being earned in the money market fund are likely to fall further, it's still the best place to be if you want flexibility (ie, quick access to your cash in case of emergencies or other investment opportunities) and a risk-free investment.

This is especially true if you want to switch into equities in the foreseeable future.

Is it time to buy shares?

Since 2015 the local equity market has been sideways, up, down, sideways and down again. Right now nobody knows for sure whether the market-impact of COVID-19 is behind us or not yet done.

What we do know is that over the long-term – think ten years or more at this stage – the stock market reliably delivers better investment returns than money market funds. For long-term goals, therefore, equities are a better bet than interest rates.

Given the economic uncertainty we all face as a result of the global response to COVID-19, we favour a staggered approach to investing in equities. You can read why in Taking Advantage of a Crash.

If you follow this approach, the money market fund remains a good option – it gives you the flexibility you need to transfer portions into the equity market, bit by bit, and to put in larger amounts if the market dips.

Obviously, if your view is that it's best to wait a bit longer, the last thing you want to do is lock your money in a fixed deposit – Murphy's Law dictates that right after you do so will be perfect time to get into equities.