Money market unit trusts and income funds

I recently looked into some of the great interest rates that banks are offering on fixed deposits. But what if you don’t want to lock your money away for a fixed period of time? Money market unit trusts and income funds are alternative interest-generating investments which you could consider if you want the flexibility to access your money immediately, and are excellent places to keep your emergency fund.

Money market unit trusts

A money market unit trust is not a bank account, but a collective investment scheme offered by investment management companies such as Coronation, Allan Gray, Stanlib, etc.

Most money market funds are currently offering yields above 8%. The minimum investment amounts vary depending on the fund manager, and can range from R10 000 to R50 000. Your money is available within 24 hours and interest can be paid out monthly or can be reinvested.

A money market unit trust is a good option for investments of up to a year where you want limited capital risk, immediate access to your funds, and want to get interest rates above what a bank would give you on an immediate-access account.

As these funds invest in short-duration money market instruments, the returns will be linked to movements in interest rates.

The funds are invested with various financial institutions and the fund manager targets a return above a bank deposit. One way fund managers achieve this is that they negotiate wholesale rates with banks and get a better interest rate than an individual could.

They may also invest in higher-risk deposits, such as a second-tier bank that may not have the same investment rating as the larger banks. This means there is some risk to the investment and your capital is not necessarily 100% guaranteed.

In 2014, some fund managers had exposure to African Bank in their money market unit trusts, and when African Bank collapsed, their funds lost money. However, as money market funds are diversified across multiple financial institutions, the risk can be lower than if you had all your money with one institution that then defaults.

If a money market fund is offering an interest rate well above other money market funds, it could suggest that higher risk is being taken, so do your homework. Money market unit trusts do charge management fees and you need to first confirm whether the interest rate quoted is before or after the management fees.

Income funds

Income funds are offered by investment management companies. These funds invest in cash and bonds (both government and corporate bonds), both locally and internationally. They aim to deliver returns above money market funds. For example, the 10X Income fund currently provides a yield of 9.5%. It has a return objective of 2.5% above inflation over a rolling three-year period.

While the return from an income fund is primarily interest, it does invest in bonds, so there is some exposure to capital gains and losses in the short term. Therefore, an income fund is preferable for investments of at least one year and up to three years. However, your funds are available within 24 hours and the interest can be paid out monthly.

As income funds invest in both corporate and government bonds this makes them attractive if interest rates are expected to fall. This is because of the inverse relationship between bonds and interest rates (see explanation below).

This means if interest rates are cut next year, while the yield on the fund may decrease, the capital value of the investment would increase. If you were invested in a money market fund, you would only experience a reduction in the yield, without a gain in the capital value of your investment.

How bonds work

When we talk about the capital value of a bond, we are referring to the market price or the present value of future cash flows that the bond will generate.

Bonds and interest rates generally have an inverse relationship. When interest rates rise, the value of existing bonds tends to fall, and when interest rates fall, the value of existing bonds tends to increase.

Most bonds have a fixed coupon rate, which is the interest rate that the bond pays annually based on its face value. For example, a bond with a face value of R1 000 and a 10% coupon rate pays R100 in interest each year. This fixed coupon rate remains the same throughout the life of the bond.

When interest rates rise, new bonds issued in the market typically offer higher coupon rates in order to attract investors. As a result, existing bonds with lower coupon rates become less attractive to buyers, leading to a decrease in demand. Investors may be less willing to hold onto existing bonds with lower coupon rates, as they could potentially earn higher returns elsewhere. This decrease in demand puts downward pressure on the capital value of existing bonds.

When interest rates fall, new bonds (or other interest-linked investments) are now issued at lower interest rates and therefore existing bonds with higher coupon rates become more attractive to investors, thus increaseing demand for these bonds. This increases the capital value of the bond.

The extent to which a bond’s capital value changes in response to interest-rate fluctuations is influenced by its duration. Duration is the length of time before the bond reaches maturity and is paid up. Bonds with longer durations tend to experience more significant price movements in response to interest-rate changes compared to bonds with shorter durations.

For example, if interest rates decrease by 1 percentage point, then the capital value of a three-year duration bond would increase by 3 percentage points and the capital value of a six-year duration bond would increase by 6 percentage points.

If you plan on holding the bond to maturity, then the relative capital value of the bond is irrelevant as you will receive the agreed coupon rate and the face value of the bond on maturity. It only matters if you plan on selling the bond.

This article first appeared in City Press.