Many investors will by now be familiar with the RSA Retail Bond range offered by National Treasury that offers aggressive interest rates for savings between R1000 to R5 million.

What few people are aware of however is that National Treasury offers a Restart option for people to capitalize if the interest rates increase whilst they are locked into an investment period.

Currently the interest rate on a 5 year RSA Retail Bond (Fixed Rate) is 8.25% and a two-year option pays 7.25%.

This compares very favorably to current money market rates of around 5.5% and even five year fixed deposits are only offering 7.5%.  In fact this rate is probably higher than what you are paying on your mortgage repayment.  However if interest rates go up by 250 basis points over the next two or three years, investors may be better off in a shorter-term investment.

Fixed deposit with increasing rates

It is this exact reasoning that led Treasury to introduce the re-start option in 2007. If a year into your investment the interest rates increase, you can opt to re-start your investment at the higher rate without any penalties.

Moreover, you do not have to select the same time period as your previous investment, and this is where it gets really interesting. While 8.25% is a great return, the rule of thumb is that you should not stick your money in cash if you are investing for more than three years.

The Restart Option lets you have your cake and eat it – although this was probably not Treasury’s intention at the time.

Lower investment period with no penalty

For example you could opt for the five year bond today and in a year’s time restart the investment and select the shorter two-year option, effectively reducing your investment period to three years even though you have benefited for a year from a five year rate which is 50 basis points higher than the current three-year rate on the RSA Retail Bond.

The Restart Option can be selected even if interest rates stay the same, so for ease of comparison we assume no rate increase when comparing it to a three- year fixed deposit.  Banks are paying around 7% for a 36 month fixed deposit.

 

• A client invests R1 million into the 5 year RSA Retail bond. In the first year he/she receives 8.25% interest. The client restarts the investment now for a two-year period and receives 7.5%.

 

• Based on the nominal interest rate (leaving out compounding affect) the client would have earned R232 500 from the RSA Retail Bond over three years compared to R210 000 in a three year fixed deposit.

 

If interest rates go down, you just don’t choose to restart and continue to receive the same interest rate.

 

The catch

Of course there is always a catch and it is one that advisers needs to ensure people understand before investing. Unlike a bank’s deposit rate, the RSA Retail Bond rate is not linked to the repo rate but rather to the movement in the vanilla bond rate.

It also only increases its rate at half the rate increase of the bond, so if the bond rate goes up by 100bps, the RSA Retail Bond will increase by 50bps.  Bonds do not necessarily increase at the same rate as the repo, especially if they have already factored a rate increase in.

Ian Cruickshanks, economic analyst at Nedbank says currently the market has priced in a 50bps hike in the first quarter of next year. Also the bond yield on the benchmark R157 bond has actually decreased over the last month from 7.9% to 7.3% as inflation appears more benign.

This also creates pricing mismatches which shrewd investors can manipulate. At the time of writing this article the two-year RSA Retail Bond’s interest rate was nearly 100 basis points higher than its equivalent, the R206. It is likely that at the next price reset the RSA Retail Bond will be priced down, but investors would already be locked into the higher rate, while  investors who come in after the price adjustment will receive a lower interest rate even though there has been no decrease in the repo rate.

However if we do enter into a sustained period of rate hikes, the bond rates will move up but will lag the cycle by several months.

It is important that investors considering the Restart option understand how the pricing works and that, unlike their money market account, the impact of an increase in the repo rate will not translate to an equivalent increase in the RSA Retail Bond rate.

The politics of funding the bond:

The RSA Retail Bond is a bit confusing because it is not actually a bond but a fixed deposit priced off a bond and its funding is fundamentally different.

A typical retail bond:

In the case of the Nedbank Retail Bond, Nedbank went to market and raised capital through the retail market by selling a fixed term investment at a fixed interest rate. These are done in tranches as per a normal bond.

The interest rate Nedbank pays on the retail bond is set taking into account what Nedbank would have paid had it raised comparable long-term funding through the capital markets by issuing debt instruments under its domestic medium -term programme.

The benefit of issuing retail bonds (to retail clients) as opposed to capital market bonds (to institutional investors) is that Nedbank derives the benefit of originating funding which is more Basel III friendly (retail funding vs wholesale funding) for an equivalent cost of funding.

RSA Retail Bond

In the case of the RSA Retail Bond there is no underlying bond issued although the pricing is linked to an equivalent government bond.

The funds raised through the RSA Retail Bond form part of government’s overall debt and the debt servicing cost comes from the national Budget.  Currently government spends 8% (R71.4bn) of the budget on debt servicing costs.

The RSA Retail Bond is a drop in the ocean of current debt at only R9.4bn however what happens when the Restart Option starts to look more attractive? Although Treasury says at this stage the Restart Option has not been popular, that is simply because rates have not being going up. This could change significantly once we move into a rate hike cycle.

If more and more investors switch to the RSA Retail Bond it could decimate longer-term bank deposits. Banks play a critical role in matching private deposits with private borrowing.

Taking this to its end point, if banks lose deposits as a result of unfair competition from a taxpayer funded entity which does not have to factor in profit margins, there will be less money to lend and could ultimately impact on private investment. This is a classic case of the public sector crowding out the private sector.

While Treasury is to be commended for trying to encourage savings, it needs to firstly understand the impact on the private sector and it definitely has to reconsider its Restart Option especially if people can Restart their investment with a shorter time period.

 This article first appeared in InvestSA – a monthly investment magazine available at CNA