Investor update Standard Bank retail note

South Africa

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21 August 2006

Performance update

Highlights: •

Nicolette Roussos* +27-11-378-7227 [email protected]

Standard Bank’s original 3-year retail deposit note, the SBR001, was listed on February 17th 2006 and performed in line with other retail investments over its first six months, returning:

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3.55% (compared to 3.50% for a wholesale negotiable certificate of deposit, and 3.59%, on average, before fees for the six months ended June 2006 of money market funds); or, on a floating rate basis,

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Jibar flat compared to below Jibar returns of Standard Bank fixed deposits and RSA wholesale benchmark bonds.

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The current interest rate environment suggests there will be further interest rate hikes, which places floating rate note instruments in a favourable light compared to fixed rate instruments.

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Although essentially a conservative investment instrument, Standard Bank’s deposit note does carry a degree of credit risk that investors should be aware of.

1.

Retail note basics

By investing in Standard Bank’s original 3-year retail note, listed in February this year, investors receive 3month Jibar1 on a quarterly basis instead of fixing their interest rate for three years. Standard Bank is launching another retail deposit note, this time for a 5-year term and paying Jibar + 15 bps. In this investor update document, we review the performance of the original retail note relative to other comparable retail instruments and comment on possible future interest rate scenarios and risks. The structure of floating rate notes, which is the asset class type of Standard Bank’s retail deposit note, was discussed in our document, “New note on the block”, January 23rd 2006. Here, we briefly review the most important features of floating rate notes or floaters. For a given interest period, interest on floaters accrues at the interest rate that prevailed at the beginning of the interest rate period. In this way:

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The interest over the term of the floater adjusts to prevailing interest rate conditions;

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Trading costs and credit considerations aside, the floater trades at par (i.e. the initial amount invested) at reset dates, and close to par between reset dates; and, therefore,

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The interest rate risk of a floating rate note is small (compared to conventional fixed rate instruments). The primary risk indicator is credit risk (i.e. exposure to Standard Bank) and the note can, therefore, be considered primarily a credit instrument.

Figure 1 illustrates the interest-accrual process of a floating rate note. Figure 1: Timeline of interest determination for a floating rate note

Interest rate for a period is determined from reference rate level at reset date i.e. at start date in this case

Interest is received on principal at each reset date value of note at each reset date pulls to par

start date interest

interest period

interest period reset

interest

reset

interest

interest period reset

interest + principal

interest period reset

Full term or maturity of deposit Source: Standard Bank Group

2.

Note performance

Standard Bank’s retail deposit note is a conservative investment instrument. From a pure interest rate exposure perspective, the note adjusts to prevailing conditions and so yields higher returns when interest rates rise. June and August’s interest rate hikes have resulted in Standard Bank’s original note’s having reset at 8.117% in August, well above the two previous resets of 7.10% and 7.08%. And, since the market expects Jibar to tick higher from current levels, these higher rates will be captured at the reset of Standard Note: 1. Johannesburg inter-bank agreed rate, i.e., the rate at which South African banks lend to one another. Jibar is quoted for different tenors, e.g. for 3-, 6-, 9- and 12-months. It is a money market rate (annualised simple yield).

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Bank’s forthcoming issue, and at subsequent quarterly resets. Hence, since the market is bearish on interest rates, and assuming the South African Reserve Bank (SARB) does not cut rates in the near future2, the bias is for increasing returns on floaters. Figure 2 illustrates the levels of 3-month Jibar for 2006 to date. The upward trend will be captured in the interest payments of floating rate notes for all resets subsequent to the first repo rate hike on June 8th 2006.

2.1 Tracking interest rates The original Standard Bank deposit note was listed on February 17th and paid 3-month Jibar of 7.100% p.a. on May 17th. At that point, Jibar reset to 7.083% which was paid at the reset on August 17th. The current interest rate for the November 17th reset is 8.117%, that is, current 3-month Jibar. Now, the current 3x6 forward rate agreement (FRA) rate, that captures the wholesale market’s expectation of 3-month Jibar in three months’ time (at about the time of the next reset), is 8.535% (according to Bloomberg). Hence, the next resets should usher in higher interest on the Standard Bank retail notes than the current 8.117%. This demonstrates the advantage of having an exposure to interest rates through a floating rate note as opposed to fixing interest rate exposure via, say, a fixed deposit of the same tenor.

Comparison with money market and other deposit rates over three months Figure 3 compares the returns (non-annualised) over the first 3-months (February 17th to May 17th) of the Standard Bank retail deposit note, a 3-month negotiable certificate of deposit (NCD) (which is a wholesale counterpart of a 3-month deposit note), and a Standard Bank 3-month fixed deposit. The average gross performance of money market funds for the quarter ended April is also displayed. Figure 3: Retail note, 3-month fixed deposit, 3-month NCD and 3-month average money market performances

Figure 2: 3-month Jibar

1.76%

8.2%

1.68% 3-month yield

Jibar (annualised yield)

7.9%

7.7%

7.4%

1.59% 1.51% 1.43%

7.2% 1.35%

6.9% 31-Dec-05 11-Mar-06 20-May-06 Source: Standard Bank Group

29-Jul-06

SB 3month fixed

3-month NCD

SB retail MM funds note

Sources: Standard Bank Group, Alexander Forbes

For the quarter ended April 2006, money market funds averaged 1.75% on a gross (i.e. excluding costs), non-annualised basis against the 1.63% returned by the money market benchmark index, or STEFI (Alexander Forbes/SAFEX Short Term Fixed Interest benchmark). The performance of money market funds after costs are deducted could, however, under-shoot that of wholesale 3-month NCDs, that returned 1.71% over the same period. As a retail proxy for NCDs, Standard Bank’s deposit note therefore compared favourably, outperforming NCDs by 2 bps over the same period. Further, the note outperformed Standard Bank’s February 3-month fixed deposit performance by about 25 bps (gross). When comparing the performances of similar instruments, the interest rate bases (fixed vs floating) and tenors (maturity) should correspond. Even though the Standard Bank retail note is a 3-year instrument, it resets quarterly. Furthermore, a two-way market for the note exists. Hence, 3-monthly performances of the note can Note: 2. Highly improbable. The SARB is unlikely to allow policy volatility to impinge on their credibility. The risks are currently skewed towards more rate hikes.

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be compared to performances of other 3-month instruments. This was done in Figure 3. In order to expand the comparison we also consider the performances of the 3-year RSA retail bond3 over the period February 17th to May 17th, as well as the “benchmark” R194 (matures February 2008) and R153 (matures February 2010) bonds.

Comparison with RSA bonds on a floating rate basis RSA bonds are fixed rate instruments: they pay fixed interest (but prices, of course, will fluctuate with the interest rate environment). So in order to make a performance comparison with a floating rate note, we “asset swapped” the fixed bonds to convert them into floating rate equivalents4 that pay Jibar plus a spread for the remainder of their maturities. Although retail investors cannot generally access the swap or RSA benchmark bond markets, the performances on a floating rate basis of the RSA benchmark bonds provide a comparative basis for the performances of the RSA retail bond and the Standard Bank deposit note. The results are shown in Figure 4. Figure 4: RSA benchmarks and retail bond spreads (non-annualised) vs SB fixed deposit and retail note

Figure 5: 6-month returns (fixed rate basis)

4.0% 6-month yield (non-annualised)

3-month spreads to Jibar

10 5 0 -5 -10 -15

3.2% 2.4% 1.6% 0.8% 0.0%

-20 R194

R153

RSA 3year

SB 3year fixed

SB retail note

Sources: BESA, National Treasury, Standard Bank Group

RSA 3year

SB retail note

3-month SB 3NCD year (rolled) fixed

SB 3month fixed (rolled)

Sources: National Treasury, Standard Bank Group

Owing to their less risky nature (compared to bank credit), RSA benchmark bonds pay less than 3-month Jibar on a quarterly basis (their spreads to Jibar over three months are negative in Figure 4). The 3-year RSA retail bond, however, paid a positive spread to Jibar and would, therefore, have outperformed Standard Bank’s original retail note (that pays Jibar flat) had it been bought on February 17th 2006. RSA retail bond rates re-adjust monthly provided underlying interest rates move by more than a threshold amount. Hence, depending on when the bonds are bought, RSA retail bonds can offer a positive spread to Jibar. The disadvantage of investing in an RSA retail bond compared to the retail note, however, is that the investment is fixed for the entire term, whereas the presence of a two-way market for Standard Bank’s deposit note on the JSE means that the underlying cash investment is not necessarily tied down for the maturity of the note. By the same token, 3-year fixed deposits immobilise cash for three years. And, Standard Bank’s 3-year fixed deposit on February 17th 2006 would have underperformed the 3-year RSA retail bond and Standard Bank’s deposit note on a gross basis.

Six month return comparisons Figure 5 shows the 6-month non-annualised returns for 3-year instruments, as well as the rolled returns for an NCD and 3-month fixed deposit (bought on February 17th and rolled for another three months on May 17th). Note: 3. www.retailbonds.gov.za 4. It is assumed that the asset swaps occur on the first reset date i.e. February 17th 2006, for the entire remaining maturities of the assets. The Bond Exchange’s (BESA) swap zero rates were used in the calculations.

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Although the relatively lower liquidity of 3-year investments may lead one to expect a higher rate (and hence return) in compensation, the performances on a fixed-rate basis over 6 months of the 3-year instruments depicted in Figure 5 do not offer a substantial upside relative to two consecutive 3-month NCDs or Standard Bank’s retail note. The bottom line is that, since February 2006, Standard Bank’s retail note has offered value from both a liquidity and performance perspective.

2.2 An eye on the longer term At this point in time, domestic interest rate curves are pricing in a further 60 to 70 bps’ worth of interest rate hikes over the next six months. Hence, investment instruments that track increasing interest rates should outperform fixed investments, at least over the short term. However, should interest rates begin to retrace next year, the upside to floating rate note performance may begin to dwindle. Domestic macroeconomic fundamentals are still strong and would favour flat to lower interest rates provided the rand and oil prices stabilise, which could well materialise in the medium term.

3.

A word on the risks

In order to complete the comparison picture, it is also important to note that there are also other fundamental differences and risks between Standard Bank’s deposit note, “vanilla” fixed deposits, RSA bonds and money market funds:

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RSA bonds carry no credit risk whereas Standard Bank’s retail note and deposits carry a small degree of credit risk;

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There are no costs involved with RSA retail bond investments, bank fixed deposits incur low to zero costs but the retail note does incur brokerage costs and bid-offer spreads (but no management fees or UST); and

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Unit trust costs and/or management fees are not included in reported fund performance numbers.

On the issue of credit risk, both Standard Bank fixed deposits and retail notes are exposed to Standard Bank credit risk. In theory, in the case of the retail note, credit exposure can affect the capital value of the note if a credit event leads to the market’s requiring a higher-than-Jibar coupon on the floater. For instance, should the market require Jibar + 10 bps on Standard Bank (or similar) credit, then existing floaters that pay Jibar flat would lose some capital value (depending on their maturity), which in essence would amount to the present value of 10 bps over the remaining maturity of the notes. This type of credit risk, referred to as “spread risk”, is absent from fixed deposits as the interest rate is fixed for the duration of the investment. In fairness, however, since Standard Bank is a market-maker for the note, there is an inherent floor on the credit risk attached to the note as the bank will buy back the note at par (less bid-offer spreads). Standard Bank’s current retail note has performed in line with other retail investments, and should continue to do so in the current interest rate environment. Nevertheless, investors should be aware that there are differences between various retail instruments, particularly with regards to their costs and risks.

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Research Strategy Robert J Van Eyden — Global Head [email protected]

+27-11-378-7242

CEEMEA Francis Beddington

Head — Local and Sovereign Strategy

[email protected]

+44-20-7815-2706

Stephen Bailey-Smith

Local and Sovereign Strategy

[email protected]

+44-20-7815-3671

Henry Flint

Local and Sovereign Strategy

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+27-11-378-7202

Dmitry Shishkin

Relative Value Strategy

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+44-20-7815-3181

Omega Hatfield

Head — Credit and Securitisation

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+7-495-783-3833

Roman Luchkovsky

Credit and Securitisation

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+7-495-783-3861

Ruth Mazzoni

Head — Credit and Securitisation

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+1-212-407-5033

Jose Bernal

Credit and Securitisation

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+1-212-407-5056

Denis Parisien

Local Markets Strategy

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+1-305-349-0520

Henry Flint

Deputy Head

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+27-11-378-7202

Adriana Benedetti

Credit and Securitisation

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+27-11-378-7278

Leigh Cosser

Credit and Securitisation

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+27-11-378-7239

Jason Costa

Unit Head — Credit and Securitisation

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+27-11-378-7220

Theunis de Wet

Unit Head — Local Markets Strategy

[email protected]

+27-11-378-7223

Darran Grabham

Technical Analysis Group

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+27-11-378-7228

Bonakele Hlongwane

Local Markets Strategy

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+27-11-378-7235

Michael Keenan

Local Markets Strategy

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+27-11-378-7246

Raven Moodley

Credit and Securitisation

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+27-11-378-7222

Nlhalanhla Ntuli

Quantitative Strategy

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+27-11-378-7229

Nicolette Roussos

Quantitative Strategy

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+27-11-378-7217

Wilbie Venter

Commodities

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+27-11-378-7215

CIS

LatAm

South Africa

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