South Africa is one of the few countries in the world where mortgage bonds are linked to short-term interest rates. As a result South African homeowners experience high volatility when it comes to mortgage repayments.
Considering that mortgage payments are the biggest expense for homeowners, it would make sense to find a mechanism that can decrease the volatility of bond repayments, something Reserve Bank Governor Tito Mboweni alluded to recently.
According to Wayne McCurrie of Advantage Asset Managers, over the next five years the prime lending rate is estimated to average 11%. Prime was 10,5% before the first rate increase in June and is currently at 11,5%. Consensus is that it will peak at 12,5% at which stage inflation will come under control and interest rates will begin to decrease and could come back down to 10,5%. Despite the fact that over the period mortgage rates will average close to what they were before the rate hikes began, households will still feel the monthly crunch on their repayments as they follow the interest rate cycle. Should interest rates increase by the full expected 200 basis points, a bond of R500Â 000 will cost R600 more a month until the cycle turns down again.
Homeowners would be in a far better position if their bond repayments remained static, even if they are slightly higher than the low of the interest rate cycle. Even if the net result was that they paid the same amount of interest over the period, without the volatility they would be better able to manage their financial obligation and avoid the debt crunch.
According to McCurrie, the reason why the South African mortgage bond market is driven by the short term is that the banks use short term deposits to finance their books. McCurrie says it would not make sense for a bank to offer long-term fixed rates when they are exposed to changes in the short-term interest rates when funding the loans. Only in the past four to five years have banks started to issue preference shares and corporate debt, which could be used to match the duration of a mortgage bond.
But, at this stage, the corporate long-term debt market is still too small to meet the financing needs of South Africa’s mortgage bonds. Currently, banks will offer fixed rates for 12 to 24 months. These rates are still linked to short term interest rates and the banks forecast where they expect rates to go up and then add in a margin of error. McCurrie says, for this reason, bond holders who fix their rate will most likely pay more interest over the period than they would if they had a variable interest rate. The only benefit would be peace of mind.
If South Africa changed its lending mechanisms to match mortgage bonds to long-term debt, it would not necessarily be cheaper or more expensive, but it would be far less volatile. McCurrie says that over time the long bond rate is correlated to the prime interest rate. The difference is that the long bond rate is 40% less volatile than short-term interest rates. Over the past 60 years the standard deviation, or percentage change, in one year for prime is 18%. That means that if prime is 10% on average it could fluctuate between 11,8% and 8,2% in one year. The long bond, however, only has a standard deviation of 11%. In other words, the rate would only vary between 11% and 8,9%. While this may seem like the perfect solution, McCurrie says it would require an increase in long-term debt being issued by the banks, which needs to be driven by demand.
If South Africa does follow the overseas model, it would face one serious challenge and that is limits on the ability to manipulate consumer demand.
With credit extension rising to worrying proportions, Mboweni has raised interest rates to choke off consumer exuberance. But, when former United States Federal Reserve chairperson Alan Greenspan attempted a similar tack in the US, the long bond did not increase by the same proportion over the shorter term and people simply used their bonds as cheap financing for everyday consumption.
With property values having increased rapidly over the past five years, many people have bonds well below the asset value of their homes, which they can use to finance short-term debt if the prime lending rate and the mortgage rate diverged. Nevertheless, less volatile mortgage repayments would bring a great deal of stability and peace of mind to current and potential homeowners.