February 16, 2005

By Evan Jones

As interest rates continue to plumb new depths, South Africans have widely divergent views on the subject.

For those who need finance in the form of loans the current interest rate cycle is obviously very favourable.

This is especially so if one considers that the prime interest rate has fallen from 25.5 percent in 1998 to 11 percent at present.

Not only is the current rate low, but the stability of interest rates also makes it easier for borrowers to plan their businesses.

However, for those looking to invest, and relying on high interest rates to boost their income, the picture appears less rosy.

A mere five years ago five-year term-certain annuities with capital guarantees paid a monthly annuity of 13.25 percent.

When one compares that with returns of about 6.5 percent on the identical product at the moment the dilemma facing investors becomes apparent. But is that the correct picture?

Perhaps what one needs to do is take a step back and consider the real interest rate. This is the rate after adjusting for inflation, as in the following example.

Take R100 growing at a nominal yield of 10 percent for one year. At the end of the year that R100 is worth R110 in nominal terms.

Take the same R100 and grow it by an inflation rate of, say, 6.16 percent. It grows to R106.16.

The difference between the nominal amount (R110) and the inflation adjusted amount (R106.16) is the real return (R3.84), or the real growth in your capital. The real rate is thus 3.84 percent.

If one compares the annual inflation rate with short-term interest rates then an interesting picture emerges.

The current real rate of about 4.8 percent compares with an average real rate of 3.06 percent over the past 27 years.

It should be noted that real yields were as high as 16 percent in 1999, when interest rates spiked while inflation fell. Conversely, in 2002 there was a real yield of almost minus 2.5 percent.

When one does the same comparison with the five-year yield curve the same wide range of real yields emerges. The current real yield is almost identical to the 27-year average of 3.87 percent, having been at 12.5 percent in 1999 and minus 2 percent in 2002.

What can an investor glean from all of this? The first lesson is that comparing nominal rates across periods fails to take all the facts into consideration.

Investors should rather base interest rate investment decisions on real interest rates.

Secondly, it would appear that there is potential for a cut in interest rates in the short term, which would reduce the short-term real yield.

Long-term yields appear to take account of changes in inflation expectations in a more consistent fashion. If inflation expectations remain at current levels then the long-term yields will probably remain low.

The issue remains that investors should not simply look at nominal rates, but rather base their investment decisions on real return expectations.

It becomes apparent that current income investments, while having low nominal rates, still have high real returns.


Evan Jones is the head of Cadiz Investment Products