The benchmark JSE All Bond Index (ALBI) had its worst quarterly performance since it began in 1998, falling 8.7%. The Allan Gray Bond Fund performed slightly better, but disappointingly generated a negative return over the past year.

The unsurprising news of the quarter was that Moody’s downgraded South Africa’s credit rating to junk. Fitch did similar, downgrading us further into junk. South Africa’s credit risk was the same before the announcements as it was after; all that changed was the labels attached to it. There are consequences of the downgrades, the most important being passive outflows, but it does not change our view on the fundamental value of South African bonds.

Unlike the downgrade, the COVID-19 pandemic was a severe shock with material consequences. It is too soon to know the full extent of the damage, but in times such as these it is our job to focus on the things that will protect and grow your savings. In the context of the Bond Fund, we are focused on liquidity, credit risk and duration.

Liquidity refers to the ability to sell or buy an asset at a reasonable price in a reasonable time period. It allows us to reallocate the Fund’s holdings towards the best opportunities, invest inflows and redeem client outflows. We have always managed the Fund with a focus on liquidity. 62% of the Fund is invested in the most liquid bonds in our market, namely those issued by the South African government. This comes with the cost of lower yield than the Fund could earn by investing in less liquid instruments, but the strategy proves its worth in times like these.

Credit risk refers to the probability that a borrower will be able to repay its debt. As already mentioned, the majority of the Fund is invested in South African government bonds. The government is the lowest risk South African local currency credit, since they can print money to meet their obligations. A further 7% of the Fund is invested in government-guaranteed bonds issued by Eskom and the South African National Roads Agency Limited (Sanral). The guarantee means that these offer a similar credit risk as the government. 25% of the Fund is invested in the large South African banks. These are well capitalised and profitable entities that have survived many prior crises. The remaining 6% of the Fund is invested in state-owned enterprises and corporates. We believe these will survive the current challenges, but are monitoring developments and will make adjustments if needed. The Fund has no exposure to structured credit, such as credit linked notes, or challenged sectors, such as listed property.

Duration refers to the sensitivity of the price of a fund to changes in interest rates. Bond prices move in the opposite direction to yields, and higher duration means larger price falls as interest rates rise.

At the start of the quarter, the duration of the Fund was lower than the benchmark, but higher than much of the Fund’s history. Our view was that South African bonds were pricing in South Africa’s probable challenges. We did not foresee the global reaction to the COVID-19 pandemic, which resulted in large increases in South African bond yields and corresponding falls in bond prices. This was the main driver of the Fund’s negative performance.

It is worth noting that, unlike credit-related losses, duration-related price moves do not imply a permanent loss of capital. One will get one’s capital back if one holds a bond to maturity and the borrower does not default. It also does not mean that yields will remain at current high levels. The spread between South African and developed market bond yields is extreme, and we believe South African bonds are mispriced. If South African yields return towards historical levels, the Fund should deliver good returns.

In summary, the Fund is conservatively positioned in terms of liquidity and credit risk. Its duration is less than the benchmark, but sufficient to benefit from current yields. This maximises its ability to protect your wealth amidst current uncertainty, and generate attractive returns when conditions normalise.

Thank you for trusting us with your savings. During the quarter, excess cash was invested in longer duration government bonds.

The year 2019 was characterised by ongoing trade tensions and concerns about the resultant slowdown in the global economy. The International Monetary Fund (IMF) expects global economic growth to decelerate to 3% in 2019, down from 3.6% in the previous year, with major economies leading the decline. The US treasury yield curve was inverted for most of 2019, further raising fears of an impending recession. Major central banks sprang into action to defend their respective economies, with the US Federal Reserve cutting interest rates by a cumulative 75 basis points (bp) over the year, the European Central Bank resuming net asset purchases, and the People’s Bank of China reducing the required reserve ratio for banks several times.

The monetary easing by major central banks was a boon for emerging markets – the J.P. Morgan EMBI Global Index shows emerging market bond spreads compressing from 441bp at the beginning of the year to 277bp in December. South African bonds also benefited, with JSE All Bond Index (ALBI) performance belying dismal fundamentals. Economic growth is expected to have only been 0.5% in 2019, which will not boost government revenues enough to offset increased spending, e.g. on state company bailouts. This will result in more borrowing and a ballooning debt pile. Adding to the gloom, all three international credit rating agencies (Fitch, Moody’s and Standard & Poor’s) put South Africa on a negative outlook. The only bright spot was inflation, which consistently printed at or below the Reserve Bank’s target midpoint of 4.5%.

Considering the state of the local economy, the South African credit market was incredibly robust. Issuance was at multiyear highs, exceeding 2017’s record R142bn by November. Strong volumes were recorded by banks, corporates, securitisations and state-owned entities. Interestingly, municipalities remained absent from the credit market. The credit market was favourable for issuers in 2019 due to a large amount of pent-up demand for credit assets. Credit spreads continued to tighten throughout the year – although the moves were less pronounced than in prior years – and auctions were consistently oversubscribed.
During the quarter, we added bank AT1 paper from Investec Group and ABSA Group. Although credit spreads have compressed, bank AT1 paper continues to offer relatively good value compared to bank senior and corporate paper. We also introduced SANRAL government-guaranteed bonds, which offer an attractive pick-up over their benchmark. Bonds sold off after October’s Medium- Term Budget Policy Statement and subsequent negative rating outlooks, which afforded us the opportunity to buy across the long end of the curve.

The Fund’s duration remains significantly short relative to the ALBI, a conservative stance we feel is warranted given upside risks to bond yields in 2020. February’s Budget Speech will be key to gauge how likely South Africa is to turn its finances around and possibly avoid a final downgrade to subinvestment grade by Moody’s.