In an attempt to encourage savings in South Africa the treasury’s RSA Retail Bond has inadvertently created arbitrage opportunities that shrewd investors will undoubtedly manipulate at a cost to taxpayers.
Despite its name, the RSA Retail Bond is not actually a bond that is issued, but the interest rates are determined by equivalent government bonds. These rates are set once a month, depending on the movement of the wholesale bond rates.
This delay between the actual bond rate and the RSA Retail Bond rate creates a pricing mismatch that can be arbitraged. At present the interest rate paid on the two-year RSA Retail Bond is nearly 100 basis points higher than its bond equivalent, the R206, because bond yields have fallen over the past month.
It is likely that the interest rate on the RSA Retail Bond will be reduced at the next price reset, but investors will already be locked into the higher rate, which means retail investors will score a far better deal than their wholesale counterparts.
The treasury has also introduced a restart option that allows investors to restart their investment after a year if interest rates have increased without attracting penalties. For example, if an investor selects a three-year option and the rate has increased after a year, he can simply restart and take advantage of the higher rate, despite having been paid a higher rate initially for the lock-in period.
But the crux here is that you do not have to select the same time period as your previous investment when you restart. For example, you could opt for the five-year bond today and, in a year’s time, restart the investment and select the two-year option. This effectively reduces your investment period to three years, even though you have benefited for a year from a five-year rate that is now 50 basis points higher than the 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, assume no rate increase when comparing it to a three-year fixed deposit. Banks are paying about 7% for a 36-month fixed deposit.
An investor deposits R1-million in the five-year RSA Retail bond. In the first year he receives 8.25% interest. The investor then restarts the investment for a two-year period and receives 7.5%. Based on the nominal interest rate and leaving out the compounding effect, he would have earned R232?500 from the RSA Retail Bond over three years, compared to R210?000 with a three-year fixed deposit.
According to the treasury the restart option has not been popular since it was launched in 2007 and therefore this not a significant risk. But we are entering a period of rising interest rates and you can bet that shrewd investors will spot the opportunity and the restart option will become popular. And although the RSA Retail Bond may be a boon for investors it comes at a significant cost to taxpayers.
The interest rate is reset monthly, based on the bond yields, but the RSA Retail Bond typically pays a yield of about 35 basis points higher than the wholesale rate, which means the government is paying more to borrow money from retail investors than from the corporate market.
The funds raised through the RSA Retail Bond form part of the government’s overall debt, and the debt servicing cost comes from the national budget. At the moment the government spends 8% (R71.4-billion) of the budget on debt servicing costs.
If it is paying above the going rate to borrow money the additional interest comes at the cost of the taxpayer because a larger percentage of the budget will have to go towards funding debt. At just R9.4-billion, the RSA Retail Bond is a drop in the ocean of current debt, but what happens when the restart option begins to look more attractive?
Although the pricing opportunity is not that significant for lower deposits it will attract investors with higher savings — and they are probably not the treasury’s target market. Apart from higher interest costs it will also have an impact on bank deposits.
If investors increasingly switch to the RSA Retail Bond it will effectively increase the borrowing costs of our country while decimating longer-term bank deposits. Banks play a critical role in matching private deposits with private borrowing.
The banks are also under pressure to increase retail deposits because of the Basel III requirements. One of the ways to do this is by issuing retail bonds. But they will be squeezed out by the treasury, which can use taxpayers’ money to offer above-market interest rates.
Taking this to its conclusion, if banks lose deposits as a result of unfair competition from a taxpayer funded entity there will be less money to lend, which could ultimately have an impact on private investment. This is a classic case of the public sector crowding out the private sector.
Although the RSA Retail Bond is a great initiative to encourage savings, it will come at a significant cost to taxpayers and borrowers if it becomes too popular and creates arbitrage opportunities. These are probably unintended consequences and something the treasury needs to review — starting with the restart option.