Investment Manager Commentary
Abax Investments

The Nedgroup Investments Flexible Income Fund returned 0.8% over May, outperforming the cash benchmark. Floating rate assets in the domestic market continued to deliver yield enhancement.

The ongoing political tension resulted in nominal bonds trading at levels weaker than where we see fair value. We decided to extend duration in the fund by purchasing nominal government bonds with roughly five years to maturity. This moved the duration of the fund from 0.31 to 0.74 years. We have focussed on maximising the yield of the fund by accumulating good quality floating rate assets at very attractive levels. In recent months, we have increased exposure to solid names such as Old Mutual, Santam and Steinhoff credit.
Our exposure to inflation-linked bonds remains at zero as we believe that real yields are well below fair value. With real yields at low levels ILBs will be at risk of capital loss if further interest rate hikes materialise. We continue to hold preference shares as yields in this asset class are very attractive on both a pre-tax and post-tax basis.

Our currency exposure was reduced from 2.6% to 2%, and used this weakness, following the rumours concerning the finance minister’s arrest, as an opportunity to further reduce exposure to foreign currency. This low level reflects our view that the rand is now significantly undervalued. SA continues to struggle with fundamental weaknesses, but we believe that the large gains from having offshore exposure have already materialised and the risk/return balance at these levels is not attractive in the case of foreign fixed income exposure.

In SA we believe that further rate hikes are necessary as inflation continues to climb this year. The extent of the rate hiking cycle is to some extent dependent on the path of US interest rates. With the US Federal reserve looking increasingly likely to hike rates by September, the pause in the SARB’s tightening cycle may prove short-lived. The decision by the SARB at the May meeting to pause in the context of further tightening has merit due to weak economic growth and lower than expected inflation. It will be important to closely monitor any change in the SARB’s rhetoric regarding inflation before the next meeting as currency weakness could result in inflation projections being marked higher again. This could precipitate a resumption of the tightening cycle at the July MPC meeting.

We are happy with the high level of credit quality in the fund and the yield pickup we are able to generate. The current market environment creates opportunities for yield enhancement and we will add to our holdings as we see value. We will continue to focus on maximising yield, while looking for strategic allocations to the various income asset classes in order to generate additional performance.

The weighted average yield of the Nedgroup Investments Flexible Income Fund is currently 9.7%.

Global markets started the year with an extremely negative tone as equity markets fell sharply from the first trading day. The rand started the year at R15.47/USD and moved above R16/USD in the first week. From those levels the currency experienced a 'flash crash' in early morning trading hours as Japanese investors sold rands aggressively into an illiquid market. The rand traded as high as R17.92/USD before recovering. The rand ended the month at R15.89/USD, a depreciation of 2.7% against the USD and 2.4% on a trade-weighted basis.

The SARB hiked the repo rate from 6.25% to 6.75% at the January MPC meeting. They believe that the inflation outlook has deteriorated sharply due to rising food prices and the depreciation of the rand. The rate hike supported the SARB's credibility with respect to inflation targeting and led to a sharp recovery in the local bond market. Bonds yields rallied and the ALBI returned 4.6% while inflation linked-bonds delivered 0.8%.

Japan became the fifth central bank to move interest rates into negative territory as they cut the official rate to -0.1%. Statements from the ECB indicate that further easing is likely in Europe. The easing bias in Japan and Europe contrasts with the US Fed which hiked rates in December and signalled further hikes going forward. While the US economy continues to grow steadily, a slow global growth environment and monetary easing from other central banks will limit the Fed's ability and need to hike rates.

In SA there has been a concerted effort to rebuild some of the credibility that was damaged by President Zuma's sacking of Finance Minister Nhlanhla Nene in December. The new Finance Minister Pravin Gordhan has signalled the intention to aggressively tackle the deficit in the upcoming budget. Government, Treasury and the Reserve Bank have indicated a strong desire to maintain SA's investment grade credit rating. While this may not be achieved, an aggressive reform agenda will be positive for SA's longer-term prospects.

The Nedgroup Investments Flexible Income Fund outperformed the money market for the month of January. Domestic asset performed well due to the high yield on the portfolio. We also added to performance by locking in rates on a portion of the fund as yields rose. The offshore allocation was a slight detractor as SA-related names continued to come under pressure due to events in December. Preference shares had a strong month and added to performance.

During the month we increased duration from 0.7 to 0.8 years as yields remained elevated. This was done through swaps as it enables us to gain fixed rate exposure while holding our existing floating rate assets. We have focussed on maximising the yield of the fund by accumulating good quality floating rate assets at very attractive levels. The 50 basis point rate hike further boosts the yield on these assets.

Our currency exposure was maintained at 2%. This is a low level which reflects our view that the rand is now significantly undervalued. SA continues to struggle with fundamental weaknesses, but we believe that the large gains from having offshore exposure have already materialised and the risk/return balance at these levels is not attractive in the case of fixed income exposure.

In SA we believe that further rate hikes are necessary, but the extent of the rate hiking cycle is dependent on the path of US interest rates. Inflation in SA is currently 5.2%, but is expected to rise sharply in coming months. It is likely to be close to and above the 6% upper target over the medium term. In this environment we would be positioning the portfolio for further rate hikes.

We are happy with the high level of credit quality in the fund and the yield pickup we are able to generate. The weighted average yield of the Nedgroup Investments Flexible Income Fund is currently 9.5%.