/ 21 August 1998

Buying and selling other people’s

money

Michael Metelits

One of the more puzzling, and confusing, ideas in finance is the notion of a money market. But money markets are actually relatively simple, and form a key part of a diversified investment portfolio.

When you borrow money, you are ”buying” money now in exchange for money in the future. The ”price” of this money is the interest rate, or the amount in excess of the amount of the loan you will have to pay.

Money, like any other commodity, can be bought, sold and borrowed; mainly it is bought and sold as debt, as in a loan or a bond.

Bonds are often called ”fixed-income securities” because, unlike stocks, where the dividend can vary widely from year to year, bonds pay their principal – the amount of the loan – plus their interest rate, which is usually fixed.

So all bonds are technically part of the money market, but the term ”money market” is usually reserved for fixed- income securities with a maturity date of one year or less. Longer-term fixed income securities trade in the bond market.

The primary instruments traded in the money market in South Africa are negotiable certificates of deposit (NCDs) and banker’s acceptances (BAs), according to Dennis Dykes, Nedcor chief economist.

These securities are primarily issued by banks and insurance firms – financial institutions with short-term needs, both predictable and unpredictable, for money.

So instead of keeping huge amounts of cash lying around not earning interest, or earning only current- account rates, these firms issue a security to borrow cash when they need it.

When you buy NCDs or BAs, these institutions take your money and give you a piece of paper which indicates how much money they owe you (the principal), and when they have to pay it back (the maturity date).

That, in essence, is a money market transaction. The loan period is shorter and the method of paying interest, the price of the loan, differs from a conventional bond.

With a normal bond at par, you’d pay R1 000 000 principal up front and expect quarterly interest payments of, say, 10% until maturity date, and then get your R1 000 000 back when the loan matures.

That 10% payment every quarter is the price the firm or government pays you to borrow your money.

While maturity dates in bonds can be as long as 30 years, a maturity date of three, six, nine or 12 months for money market securities means that the standard method of paying fixed-income interest in quarterly payments will not do. Instead, money market instruments are ”discounted”. That means if you buy a R1 000 000 NCD at a discount rate of 10% you’d pay R900 000 up front and get R1 000 000 back at maturity.

You wouldn’t receive any interim interest payments, because the ”price” of the loan is factored into the lower amount of principal you paid up front.

This discount rate is the method of paying interest in the money market, based on the principle that money now is worth more than money in the future. In the example above, money now is worth 10% more than money at maturity.

With many of these instruments, the price tends to rise as the maturity date comes near.

The reason for this is simple: at maturity date, the holder gets the full value of the security, so the price moves closer to full value (it is discounted less).

Because the paper will be worth par, or face value, at the maturity date, the discounted price moves toward that figure as the maturity date approaches.

If you bought the paper at a 10% discount for R900 000 three months ago, and you’re selling it close to the maturity date, the buyer stands to get R1 000 000 very shortly.

So she has to pay you pretty close to R1 000 000, since you would be getting that at maturity date if you didn’t sell. That’s why the price moves up.

According to Dykes, these markets are ”deep”, with a great deal of volume and a ”strong secondary market”.

This means a lot of firms issue the instruments, and other people buy and sell them once they’re issued, rather than just holding them to maturity.

Lots of issuers guarantees competition in discount rates, and lots of buyers means you can unload your security for cash if you need to.

Short-term securities like NCDs, BAs and, to a limited extent, commercial paper (a corporate version of what insurance firms and banks do to raise cash) can be quite useful for investors.

Since maturities are short, they don’t tie cash up for too long and they tend to earn more interest than would money left in a current account.

You can lose money if you buy, say, an NCD at 10%, lock your money up for nine months, and rates spike to 20% for three months in the meantime. You’ve lost the opportunity to earn that 20%.

Credit risk is also involved. When you give a firm R900 000 and expect R1 000 000 in nine months, you’re betting that they’ll have it, and not go bust between now and then.

That’s how credit-rating agencies like Fitch Ibca and Moody’s make their livings – by rating the likelihood of fulfilment or default for issuers of fixed-income securities of all types.

If an issuer of money market instruments is rated badly, its securities will sell at a deep discount, which means you have to give the issuer less money up front to get the face value of the instrument at maturity.

This reflects the rating agency’s belief that it’s less likely that you’ll get that money at maturity. Deep discounts are cheaper, but obviously have more risk associated with them.

In short, by lending money over the short term to financial institutions that need it, investors can reap excellent rewards, keep ahead of inflation, and perhaps offset other securities mishaps – or borrow the money to speculate their way into a mishap.