There were some encouraging signs for South African fixed income assets over the quarter. Consumer price inflation fell to below 5% per annum. Improving global growth supported emerging markets with R26.7bn of net foreign inflows into South African bonds over the quarter. The probability of political change increased, headlined by growing criticism of current ANC leadership and pressure on foreign firms such as KPMG and Bell Pottinger.

These improvements, while positive, do not materially improve South Africa’s economic fundamentals. Thus we have not changed our fixed income investment view.

Low economic growth and poor tax collections suggest government revenue will fall short of expectations. Conversely, government expenditure is expected to grow in excess of inflation. The difference between the two, the fiscal deficit, is likely to be worse than forecast and add to already-high government debt.

Similarly, the financial position of state-owned enterprises (SOEs) continues to worsen. The recent South African Airways bailout caught the public’s attention, but it is the much larger challenges at Eskom that should be monitored. Eskom’s 2018/19 tariff application to the National Energy Regulator of South Africa (Nersa) referenced a Deloitte report, commissioned by them, which concluded that 19% per annum electricity tariff increases are required over the next five years for government debt to GDP to merely stabilise at current levels. We don’t know how accurate Deloitte’s findings are, but Eskom’s financials support the conclusion that either the government must bail-in some of Eskom’s debt, or South Africans must pay substantially more for electricity. These scenarios, and similar at other SOEs, are likely to be negative for fixed income investments.

We believe there are above-average risks of further sovereign ratings downgrades, a weaker currency and higher bond yields. We manage our clients’ investments within this context.

Over the quarter:
-The Fund’s modified duration was reduced from 4.9 years to 4.3 years
-Cash and money market instruments were increased from 18.6% to 30.4% of Fund
-Longer duration government bonds were reduced from 39.7% to 33.5% of Fund.
Commentary contributed by Mark Dunley-Owen

Sentiment towards South Africa is poor. It is tempting to believe that excessive bad news is priced into South African assets, which should deliver attractive returns if reality turns out to be less negative than feared. Unfortunately, we do not believe this is likely.

The fundamentals of the South African economy are deteriorating under the current government. One way to highlight this is to discuss South Africa in the context of variables which we regard as important to any investment, namely cashflow, financial flexibility and management.

Three investment questions to ask are:

Does South Africa generate sustainable positive cashflow?
Does South Africa have the financial flexibility to respond to an uncertain future?
Does the management of South Africa, i.e. the government, have a track record of value creation?

Government debt to GDP provides an answer to the first two questions. A material rise in debt to GDP over a relatively short time period indicates sustained negative cashflow, most likely due to excessive and unproductive government spending. As debt to GDP rises, financial flexibility falls and the government has fewer ‘bullets in the chamber’ to respond to surprises.

South Africa’s government debt to GDP has risen from 26% in 2009 to 51% today. In rand terms, government debt has increased by R1.1 trillion rand over the last 5 years, suggesting the government is spending over R200 billion per year more than it earns. This trend may worsen if government revenue falls short of and expenditure exceeds forecasts following recent political events. This cannot continue indefinitely, and probably for not much longer, without negative economic consequences such as further downgrades, currency weakness and higher borrowing costs.

Government’s track record on value creation is similarly poor. A measure of this, which affects all South Africans, is the quality of services provided by the state, such as electricity, education and health - all of which are poor. Those with some accounting understanding should look at Eskom’s balance sheet and cashflow statement to get a sense of the mismanagement. Others can consider that the combined construction cost of Medupi and Kusile has risen to R295 billion. To put that in context, one could build 22 Sandton Cities, the most highly valued shopping centre on probably the most expensive land in South Africa, for the same price.

South Africans, ourselves included, are often guilty of excessive pessimism. We wish that were true today, but objective measures such as these suggest otherwise.

In the midst of these challenges, we remain focused on maximizing long-term client wealth. In the Bond Fund:

We maintain a lower than benchmark duration.
We favour a barbell approach, combining low risk money market securities with long duration bonds that we believe price in some of the risks.
We have minimised exposure to parastatals with weak financials. The majority of the Fund’s parastatal exposure is to Transnet and ACSA, which we regard as relatively stronger credit.
Investments during the quarter were made in line with this strategy.

Commentary contributed by Mark Dunley-Owen

The first quarter of 2017 was characterised by a gradual improvement in South Africa’s economic outlook, undone by the cabinet reshuffle on 30 March and the subsequent downgrade by S&P Global Ratings.

Prior to this, South Africa’s short-term economic indicators were improving. The current account deficit narrowed from 6.2% of GDP in 2014 to an acceptable 1.7% of GDP, inflation appeared to have peaked at 6.8% in December, and the rand strengthened by about 20% against developed market currencies. The prices of local fixed income assets reflected the sentiment that times were getting better. The yield on the 10-year South African government bond rallied 140 basis points from its December 2015 high and the JSE All Bond Index (ALBI) returned more than 50% in dollar terms from its low in January 2016.

In the one week following the cabinet reshuffle, the 10-year South African government bond reversed all its quarterly gains and the ALBI lost 10% in dollars.

The government’s decision to remove Pravin Gordhan and other ministers has materially increased South Africa’s risks. At time of writing, it is too soon to predict the final outcome of these actions, but a reasonable conclusion is that the range of future scenarios has decreased. Two different and binary scenarios now seem more likely than the middle ground.

One scenario involves the current political leadership remaining and worsening mismanagement of a struggling economy. The other scenario involves sufficient political and social pressure to force leadership change that leads to more rational future economic policies. Which of these scenarios occurs will have a large but opposite impact on South African assets, particularly rand-denominated government bonds.

Current bond yields are a weighted average of these two outcomes. This makes investing particularly difficult, as short-term performance may largely depend on politics. We have no unique insight in this regard, and instead remain focused on limiting risk so that our clients have a reasonable chance of adequate long-term returns.

It is worth noting that, irrespective of short-term developments, long-term fixed income performance is related to South Africa’s economic prospects, in turn dependent on structural challenges such as capital investment, policy certainty and education. Sustainable improvements in these will require strong leadership making difficult decisions.

Money market instruments continue to offer good relative value. One-year bank deposits require little duration or credit risk, yet offer real returns in excess of inflation.

Duration was marginally increased by adding long duration government bonds. Airports Company South Africa (ACSA) and Standard Bank exposure was increased at attractive yields. We continue to favour a combination of low-risk bank money market instruments, long duration government bonds and medium duration corporate fixed rate bonds.

Commentary contributed by Mark Dunley-Owen

The Fund returned 14.9% in 2016 versus the JSE All Bond Index (ALBI) return of 15.4%. The underperformance was largely due to the Fund having lower duration than the ALBI. South African bonds returned 27% in US dollars and outperformed most global markets with developed bond markets returning 2%1 and emerging markets 10.2%.

Allan Gray aims to invest in assets at a price below their intrinsic value, with the expectation that the price will increase over time to reflect value. We apply this investment philosophy across asset classes, including fixed income instruments held by the Allan Gray Bond Fund. However, it is challenging to determine the intrinsic value of fixed income investments since doing so requires making macroeconomic forecasts, which are seldom accurate over the short term.

2016 is a case in point. A year ago, few would have predicted the rand would appreciate by 26% against the British pound, South Africa would maintain its investment grade status or Donald Trump would threaten multi-decade trends such as declining inflation and increasing globalisation.

2017 is likely to contain similar unknowns. Consider one widely held forecast, namely that the Trump presidency will introduce expansionary fiscal policies. This may turn out to be true, but the success of such policies is less certain. More importantly, the implication of US policies on South African bond yields requires numerous assumptions such as the pass through from US growth to South African inflation and the effect on South Africa's risk premium. The combined probability of predicting these correctly is very low, which makes relying on short-term macroeconomic forecasts a poor investment strategy.

Instead, we try to understand a few important trends over the long term. Currently, we believe the following:
o Global and South African uncertainties, and thus risks, are high.
o Global bond yields are low relative to history and do not compensate for above-average risks.
o South African bond yields are low on an absolute basis, but fair relative to alternative investments.
o Within the Fund's investment universe, short and long duration instruments offer relative value. Yields on short bank instruments remain attractive due to bank funding requirements. Long duration government bonds are pricing in reasonable long-term inflation expectations. The middle of the yield curve is exposed to foreign investment demand that is difficult to predict and susceptible to short-term unknowns.

Based on the above, the Fund is targeting higher yields than the ALBI while limiting duration risk, by minimising exposure to the middle of the curve and maintaining sufficient liquidity to take advantage of opportunities.

During the quarter, the Fund switched some money market exposure into long duration government bonds.

Commentary contributed by Mark Dunley-Owen