The delivery of the 2019 Medium-Term Budget Policy Statement (MTBPS) in October spooked financial markets. Against a much weaker macroeconomic backdrop than anticipated earlier this year, tax revenue collections kept underperforming, while an earlier call for mandatory expenditure cuts was abandoned. Moreover, underperforming stateowned enterprises (SOEs) once again took a bigger slice of the budget cake than earmarked earlier this year. With nowhere to hide, Government is once again forced to turn to financial markets with a higher borrowing requirement. The significant worsening of the fiscal outlook left Moody’s rating agency with no choice but to change the sovereign rating outlook from stable to negative.

As would be expected, both nominal and inflationlinked bond yields spiked in response to the worse than expected 2019 MTBPS. With the short end of the yield curve anchored by a benign inflation outlook as well as a reasonable expectation of a stable repo rate path, it was up to the back end of the yield curve to adjust higher. This led to bearish yield curve steepening. In terms of the 10-year point, the yield of the R2030 initially increased sharply from 9.00% at the end of September to 9.27%, but eventually managed to claw back losses to close the quarter only marginally higher at 9.02%.

A strong finish for nominal bonds helped the JSE All Bond Index (ALBI) to render a return of 1.7% for the fourth quarter, slightly ahead of the cash return of 1.6%. For calendar 2019, the importance of base accrual was highlighted by the fact that the ALBI delivered great performance, especially considering the headwinds described above – a classical example of “bad news is already reflected in the price of nominal bonds”. For the year, the ALBI returned an inflation-beating 10.3% while cash rendered a return of 6.6%.

The fund underperformed the benchmark by 0.9% on a net-of-fee basis for the 12-month period ending December 2019. This was mainly due to the more conservative positioning of the fund relative to the benchmark, specifically the underweight modified duration position during the period under review. This was partly offset by the accrual earned from the higher yielding nongovernment bond holding in the fund.

The fund is defensively positioned with a modified duration position close to that of the All Bond Index. Considering our cautious investment outlook, we continue to favour bonds with a term to maturity shorter than 25 years and an overweight exposure to short- and medium-dated non-government nominal bonds. This position reflects a balance between minimising capital loss in case of rising longer-dated bond yields, and not foregoing all of the accrual offered by the steeply sloped yield curve. The fund will benefit most in the case of bearish yield curve steepening, that is when yields of longer-dated bonds rise by more than those of shorter-dated bonds. It should also benefit in case of a repo rate reduction, especially if the fiscal situation keeps deteriorating.