guide to money markets: when buying loans of different maturities, longer-dated paper as it’s called, typically demands higher interest rates (yields). The value of longer-dated fixed-interest paper is also more sensitive to changes in interest rates, referred to as ‘duration’. This means that portfolios with higher duration will, as interest rates go up, see their capital values decrease at a faster rate than paper with a shorter duration.
“The way we see the market,” says portfolio manager Albert Botha, “is that partly due to Basel 3, which encourages banks to use longer dated funding, and partly due to the fact that in South Africa there is a large amount of money in money market funds chasing a fairly fixed level of supply – there can be quite large differences in the yields of paper that have similar maturities. So we think you can buy paper with slightly longer maturities and pick up a higher yield without taking more credit risk or increasing the duration [sensitivity] of the portfolio.”
As an example, Botha cites two auctions of Nedbank paper (which naturally carries identical credit risk). “Recently Nedbank auctioned Double A-rated paper with a five-year maturity that had a yield of roughly 7.5%. At the same time, paper with a three-month maturity was offering just 6.1%.”
Conventional wisdom would suggest that by buying the longer-dated maturity, investors would be taking on more duration risk. But Botha explains how this was avoided: “About 90% of the fund is in floating rate note paper, with the interest rate reset every three months. So the duration of floating rate paper is never more than the next reset period.” This effectively allows the portfolio to pick up the higher yield of longer-dated instruments, while avoiding the risk of becoming more sensitive to movements in interest rates.