Should money market investors be afraid of a downgrade?

Q: My husband and I are retired. Our pensions are adequate to cover our monthly expenses, but we have a substantial amount of money invested in a major financial institution.

With all the discussion around a credit downgrade, we are concerned about the money markets and how this would affect our investments.

Because of the above, and our advanced age, we would like to know whether we should rather take the money out and invest some in short term fixed deposits in the bank. We are aware of the tax implications.

The writer does not say whether she and her husband are invested ‘on the balance sheet’ of an institution through a money market bank account, or if their money is held in a money market fund collective investment scheme (unit trust). The difference is very subtle but can have a substantial impact on the end result.

When an investor purchases a money market unit trust then the underlying instruments are made up of money market instruments issued by a number of different institutions. The objective of these funds is to enhance their yield by purchasing a number of different instruments, some with higher risk that offer better return and others that offer less return but lower risk.

Generally these funds are considered safe, but there have been historic examples that show how unforeseen calamities can have a negative effect on them. Most recently the collapse of African Bank resulted in many of these funds suffering losses. This was a reminder that there are risks involved in the underlying instruments.

The alternative is to be invested directly with a banking institution, where you become an ‘on balance sheet’ liability. This then means your risk becomes easier to assess, as the risk lies only with the stability of the bank you have chosen. The downside is that the better the institution, the lower the interest they will pay you.

A good historic example might be Saambou versus Standard Bank. The former is no longer with us, while the latter has weathered a number of difficult storms.

The South African Reserve Bank released its Financial Stability Review recently which assesses, among other things, whether the financial system is resilient to systemic shocks. This would include a sovereign rating downgrade.

Part of this report commented on ‘stress testing’ performed on the local banks, which looks at what would happen in different scenarios. It concluded that even in adverse scenario testing our banks look strong. The report said that: “Participating banks are therefore regarded as adequately capitalised to withstand significant credit losses throughout the stress scenarios before taking into account any mitigating action by banks’ management”.

This suggests that the major banks are of little concern.

We would therefore say that a downgrade would have little direct effect on investors in the money market. If anything, the yields would go up.

Remember that South Africa only reached investment grade status in the late 1990s. Being below investment grade is therefore not something unprecedented.

The only benefit we could see to moving your money into a short term fixed deposit would be to obtain the same yield for less risk than in a money market unit trust. In life anything is possible, but we do not see that a South African ratings downgrade should require you to take such action.

Robin Gibson CFP ® is a director of Harvard House Investment Management in Howick.

If you have any questions you would like answered by financial planning experts, please send them to editor@moneyweb.co.za.