Necessity is the mother of invention. And in a turbulent socio-political environment like South Africa’s, wealth protecting innovations are in vogue. Few, though, are as well suited to the current climate of uncertainty than RMB’s new exchange traded fund which enables direct investment into US Treasury Bonds for SA citizens. It works in the same way as any other security on the JSE – slices of the ETF can be bought and sold in Rands just like the shares in any listed company. Bid and sale prices are quoted in local currency and as the investment falls outside of the exchange control ambit, those concerned by the Rand’s fragility are easily able to hedge themselves without having to first learn about the world of futures and options. One important rider, though. The price of this ETF is also affected by movements in US interest rates. But best to let the inventor himself, RMB’s Dr Ebrahim Patel explain – as he did for me in the interview below. – Alec Hogg       Â
This special podcast is brought to you by RMB and Dr Ebrahim Patel, who is the Alternative Asset Specialist at RMB. Ebrahim, it’s a very attractive new product that you have launched onto the Johannesburg Stock Exchange. You’ve done it through an exchange traded fund. How exactly does it work?
It is an inward listed ten-year US tertiary bond, but we’ve done it in a very unique way. Listed on the JSE, individuals and businesses are able to invest cash into a US dollar asset without SARB exchange control approval. This first inward listing of US Treasury notes on the JSE gives investors direct exposure to the Treasury notes. RMB created, issued and listed the instruments, acts as the market maker providing liquidity in the product.
Instead of the bank issuing a note such as when an investor invests with FirstRand Bank, we are now giving the investor direct access and a direct right to the capital portion of that Treasury. So the investor doesn’t take any FirstRand Bank risk, rather his or her credit risk is directly to the US Treasury Department and it’s almost as if he or she was an American buying a US Treasury bond.
Except that one can do it in Rands and on the Johannesburg Stock Exchange.
100 per cent; because of the Exchange Control, all inward listed instruments have to be lifted on the JSE and they have to be settled in Rands, but the investor has a direct right to that and has a very strong credit on the other side, being the US Treasury Department.
It’s an extraordinary product, given that it now allows South Africans to completely hedge themselves if they’re feeling nervous about the Rand or indeed to take advantage if they’re feeling optimistic about the Rand’s rate. But how does it actually work, what is the price that you’re going to be paying for this Exchange Traded Fund?
You’ll pay roughly the Rand equivalent of US$-100. It won’t track the exchange rate exactly because it’s actually a bond that’s repricing underneath, so it’s quite accessible. The tick size is very manageable.
Right now, for instance, you’d pay R1,200, if the Rand were then to go to R13.00 to the US Dollar and US interest rates don’t move, does that mean that this instrument would then go to R1,300?
That’s correct, in a simplistic way, if we leave out US interest rates, as the Rand weakens,  so should the instrument strengthen and vice versa as well.
So, it’s a very close correlation then, between what happens to the US Dollar/Rand rate.
Correct, because essentially you have an asset that’s totally denominated in US Dollars and if you have to take an example of a share where perhaps some of the earnings in the company are Dollar-based, then you know you have different earnings, maybe some are in Rands, some are in Dollars and ultimately, the effect on the share price won’t necessarily fully mirror the Rand/Dollar exchange rate. Here you have something that’s priced entirely in Dollars in the offshore market, so when you translate it locally, the exchange rate will play a major role in it.
So it’s like buying Dollar bills except that it isn’t because there’s the US Treasury bond involved. What happens when the pricing there changes, in other words, when interest rates there are altered?
Well, at the time of going to a lifting, for every one basis point increase in rates, each Dollar custodial certificate could lose about R1.30 per unit, so in a rate cycle of 100 points, that’s a full one percent rate, security will lose about 10% of its value and that’s obviously saying that the Rand just stays the same and you’re just looking at the rates. So you know 100 basis points rates is also quite a high amount for rates to rise, so it has a fairly good sensitivity to the US interest rates in the short-term.
Presumably, if the US interest rates were to rise, the Dollar would rise against the other currencies including the Rand, so the one might just offset the other.
Correct. Many of the inward listed commodities tend to work like that, where you see a rise in the commodity price and then you see the Rand weakening, and they tend to offset each other as well, so that may well be a possibility.
This is the second of these custodial certificates that you’ve produced, how’s the first one gone? I think that was on the Kruger Rand.
That’s correct. We have over R1-bn invested in the first one. It’s been well-received by the market. In fact, it’s now even gone international. We’ve taken the rights and licenced it to the World Platinum Investment Council and they’re using this custodial certificate structure for coins as their flagship model for launching platinum coins globally.
Did you guys invent this?
It’s our invention, correct.
It’s a proudly South African insight, what made you think this way?
When we were looking at the Kruger Rand Certificate as an example, we looked at how a traditional gold ETF functions, what we found is that it only caters badly to the needs of everyone. So, if you’re an investor who only wants to get gold price exposure, when you invest in an ETF, you ultimately end up paying storage and management for physical, whereas physical is not really important to you. If you’re someone to whom the physical is very important, then you don’t really have ownership of the gold because the gold’s owned by the ETF issuer, you have a claim on that issuer. It wasn’t giving the physical guys full individual ownership and it was charging the guys who only wanted the price exposure for physical. That’s not really what they wanted.
So we decided to split it into two separate products. We created the world’s first gold bond, denominated in Kruger Rands, that pays interest in Kruger Rands, purely for those investors who want price exposure and don’t mind FirstRand credit risk. Instead of paying fees on gold, they actually earn an income in gold. For those investors who want physical ownership, we decided to give them the most secure form of ownership, which is direct ownership of a numbered Kruger Rand. This is stored in a vault that belongs to them from day one that they can actually physically redeem in the form of a Kruger Rand Custodial Certificate.
Then you just took that process and applied it to US Treasury bonds.
That’s correct because what’s unique about that process, like you said, it’s the direct ownership that the investor gets to the underlying, without having the bank or any other intermediary sit between them. We thought that was quite powerful, especially in times of economic uncertainty, seeing where the world has come from. Investors tend to be more cautious with their money and we wanted to give them a product that spoke to that and gave them the confidence that they sought.
Ebrahim, how easy is it to invest in these Treasury Bond Custodial Certificates?
It’s very simple. You’ll invest in it like you would invest in any other JSE listed share. For the Dollar Bond Custodial Certificate, if you are an individual, or if you are a South African corporate, you wouldn’t have any SAAB exchange control restrictions on your investments, so you wouldn’t need to apply for permission, etc. Because it’s inward listed, you do not have individual or company limits that apply. For the Kruger Rand custodial certificate, it’s a domestic asset in any event because the Kruger Rand is a currency.
All right, so you’re worried about the Rand exchange rate, you think that US interest rates aren’t going to move a whole lot, or if they do, that it’s going to make the Dollar even stronger. This would be the product that you can acquire by phoning your stockbroker or using your online broker and literally just invest in the same way as you would another share?
Yes, and it’s found on the ETF sector on the JSE, as is the case with any of the other popular ETFs, this would be the same process.
Surely the next step would be a similar thing for the UK, say, where you have UK Treasury Bonds or German Treasury Bonds in Euros. Is this where it’s going to go to?
We certainly have an expansion plan. Without giving too much away I can say that we’ll definitely be expanding the range of assets underlying these custodial certificates because we feel in a world of economic uncertainty, where investors are cautious about how they invest, this structure gives them direct ownership of the underlying. We feel it still has many more years to run.
Who do you think is going to be investing primarily in this latest custodial certificate of yours?
I think the primary investors would be individuals and corporate South African companies. The reason that institutions may not be the biggest investors is because they still have to market off their foreign allowance because inward listed instruments still get treated off the institution’s foreign allowance. Individuals and corporates on the other hand do not have foreign exchange restrictions and there are no permissions that they need to apply for in order to purchase these certificates. Obviously, as an issuer, we have a limit from the SAAB in terms of issuance that’s monitored constantly. So from time to time we’ll also look at the amount in the market, so it will definitely be on a first come, first served basis.
Let’s just say you’re a South African working abroad, you have R10-m in the bank in South Africa that you don’t want to emigrate, so you don’t want to go through that exchange control process, but you’re worried about the Rand exchange rate, you could literally use that R10-m, invest it in this product and then it’s like you have it in Dollars.
Yes, and if you had another R10-m, you could then take that out under your allowance because the R10-m investment in the certificates wouldn’t eat into your offshore allowance at all.
So, there’s no reason now to have to worry about getting money out the country because you in fact, can get the same exposure having it in the country.
Yes, and I think that’s one of the great things about the inward listed regime, is it allows South Africans to trade assets on the JSE. It’s all Rand settled and you know you can then always work with local institutions that you have confidence in.
Ebrahim, as you said to us earlier, you have around R1-bn invested in the Kruger Rand custodial certificate, what’s your gut feel of how popular this Treasury bond is going to be?
We certainly think that similar figures, if not more, are achievable. It may take some time to take off. It’s a new concept, but we’re in it for the long run. Over time we’re confident that we can get to that level, if not higher.
It’s not the 50th, so quite a momentous occasion, exchange traded fund to be listed on the JSE, and R69-bn has been attracted by these ETFs. It seems like the public is starting to take this investment opportunity to their hearts.
I think from the academic world, in the literature itself there has long been much evidence on passive versus active investment and how the two stack up. I think what’s happened in recent years is that the academic debate, the results that you tended to see in the literature, has now become mainstream for the public to consume and you’ve seen massive companies built on ETFs. You can think of things like BlackRock, offshore and their ETF success locally. The media has also gone about educating the public. You have guys like Warren Buffett, who says: “Stick to low cost index tracking funds”. People are starting to take notice. I think also, in tougher economic times, people tend to watch their cents a bit more and they tend to look at things like cost and fees.
So when the market isn’t going up rapidly all the time, you tend to look and see what you can do to optimise it. That’s when you become aware of the effect of fees. I think the fact that these beta products have lower fees than actively managed products generally, has appealed to people. Also the fact that you can do it yourself, gives people a greater sense of control, so I think it plays into a number of important factors at the right time.
As far as your share is concerned, where does RMB make its money in this product?
What RMB does, if you look at the custodial certificate, it gives the investor, the right to capital portion off the US Treasury bond. The investor then earns an income from RMB itself. RMB received a coupon from the US Treasury Department, we keep 30 points of that, and we pass the rest on in Rands. For example, to use simple numbers, if the coupon was 2.5%, we would pass on 2.2% in Rand, and that is where essentially, we make our profit, in the sort of profit share on that coupon.
The investor will be looking, not for that two% return, well that’s nice, thank you. You’ll be doing this as a hedge against Rand depreciation.
Correct. Each investor will obviously have their own rationale for investing in it, but generally speaking, or the way we see it, the major attraction here is the exposure to the exchange rate. The fact that there is a yield that comes with it, is obviously a nice-to-have as opposed to holding Dollars flat, so I’m sure investors will take that and they’ll appreciate that, but ultimately, I think it’s a story of the Rand/Dollar exchange rate.
Just to close off with, the risks then, Rand appreciation will drop the price of this product, US interest rates rising will also have that impact?
Correct, so your risks in these products would be rising US interest rates which will drop the US face value of the bond and a strengthening Rand will then decrease the Rand value of the bond. So you want to look out for rising US interest rates and a strengthening Rand. Of course, your own individual time horizon is important because over a short-term things move up, they move down; maybe you have a long-term structural view on the way you see the Rand going ultimately. Each investor would look at it and see what it does for their specific portfolios. Maybe it’s purely diversification as well.
Dr Ebrahim Patel is the Alternative Asset Specialist Analyst at RMB and this special podcast was brought to you by RMB.
