Current context

Over the last year, most fixed income asset classes have rewarded investors with above-inflation returns. Cash returned 7.6% and government bonds returned 7.9%, while inflation over this period was 5.4%. The global environment is very supportive of local currency bonds and we have seen foreigners enter the local market as substantial buyers. In addition, credit spreads for large banks are falling, indicating good demand for credit in quality names. Not all fixed income asset classes have performed well, however. As a case in point, inflation-linked bonds returned -0.1% over the last year, due to the current downward phase of the inflation cycle.

Our perspective

The environment for fixed income investors is positive, despite the political noise we witness nearly daily and the fact that South Africa is in recession. While this is negative for the economy, it means that there is a low probability of rising inflation and hikes in short-term interest rates - which are negative for fixed income assets. In fact, consumer inflation has surprised on the low side in 2017, prompting short-term interest rate markets to price for interest rate cuts over the next year. Despite the negative growth environment and falling inflation, the South African Reserve Bank’s (SARB) Monetary Policy Committee has been erring on the side of caution by not reducing interest rates. We believe this creates good opportunity for our investors to invest in instruments offering high real yields at low levels of risk. The market is giving us a window of opportunity that may change soon.

We are still finding good opportunities in cash markets. In particular, banks are paying high yields in the front end of the curve to comply with banking regulations. We also continue to find opportunities for high real yields in the one-year and longer parts of the negotiable certificate of deposit market. We deem selective credit names attractive. However, the recent increase in demand for bank credit has seen spreads narrow and we believe the opportunities in that sector are fewer than a year ago. As such, we are searching for opportunities in other areas of credit issuance.

Government bond yields are still attractive in the medium- to longer-dated area of the yield curve, despite current political noise. We believe that building a portfolio around a single negative narrative in bonds would expose our investors to binary outcome risks, which we aim to avoid. In addition, the valuations of long-dated bonds are not merely dependent on macro drivers. Factors like the strength of South Africa’s institutions, fiscal policy and term premium play a significant role as well. We believe a lot of negative news is already reflected in the yields of longer-dated bonds. If the SARB and National Treasury maintain the current policy framework, real yields of more than 3% on these bonds are attractive in a low growth and inflation environment.

Portfolio positioning

We have been allocating capital over the various interest rate curves where they have presented high real yield opportunities. Firstly, the long end of the cash curve - where banks are willing to pay higher yields for longer-term funding - remains attractive. We have also selectively added to our government bond position in the medium-end of the curve. In addition, we participated in credit issues where credit spreads met our fair value criteria. To reduce the correlated nature of positions in the portfolio, we decided to switch a portion of the local equity position into offshore equities. We believe that the fund is well positioned for investors and savers looking for high real yields at low levels of risk.

Despite all the negative news at the moment, there are still good opportunities for investors and savers in South Africa to earn high yields. We all know that inflation is the enemy of savers and investors over time. What we have seen over the last few years is that as the rand sells off, inflation rises as import prices increase and the South African Reserve Bank (SARB) raises interest rates to maintain the inflation-targeting framework. What we are witnessing at the moment is the opposite of that effect, which is good news for savers and investors.

We are likely to see inflation falling over the course of this year. Lower inflation rates are firstly expected due to falling grain prices as good rains have been recorded in the northern maize growing areas of the country, which could lead to lower food prices in the latter part of the year. The good news for consumers is that this will lead to lower food inflation and will help the SARB in their aim to keep inflation in the target range. Secondly, the high base effect of the rand over the last year on import prices is also disinflationary.

So where is the positive news for investors then?

Interest rates in South Africa remain high, firstly due to interest rate increases over the last two years, as well as the introduction of more onerous bank capital regulations. These translate into banks paying higher rates to depositors like ourselves for the benefit of our investors. We are able to take advantage of higher rates for investors.

The opportunity is in a term we call real rates (i.e. the interest rate an instrument yields above inflation). The higher the real rate, the more beneficial it is to the investor. The most probable outlook that we see domestically is for real rates to rise: we anticipate inflation falling over the course of the year and official interest rates only following with a lag.

This will be most evident in fixed income funds. Fixed income funds lock in high real yield instruments before the inflation cycle turns and maintain those yields even though inflation and market interest rates are falling (i.e. the term ‘fixed income’ or ‘interest’). We have mentioned in previous publications that we are finding high real yield opportunities in various fixed income markets. Cash/money market yields are attractive given their short duration nature. Government bonds return a high real yield given their credit quality and liquidity, and we are also finding attractive real yield opportunities in selected areas of the credit
market.

The real opportunity for investors and savers will be in funds with a high, fixed rate exposure locking in yields that will not be available in the bank deposit market once the SARB signals that the interest rate cycle has turned. Investors will be able to benefit from the higher fixed rates in funds while inflation and market interest rates are falling, coupled with the fact that
investors in funds don’t have to be locked in for a fixed period to receive those higher yields.

We add to the bond positions on specific points of the nominal curve where the real yield remains attractive given the duration risk. We remain positive on valuations in specific areas of the credit market that offer attractive valuation metrics. We have maintained equity exposure in counters that offer attractive valuation metrics. We will continue to search for real yields that are attractive at an appropriate level of risk.

The strength and stability of the SA bond market was tested this year through various global and local factors that have longer term consequences; such as Brexit, US politics and events in our own SA political arena. Coupled with a protracted interest rate hiking cycle and low growth economy, this created an environment of uncertainty for investors. It is in times of uncertainty that fixed income instruments can bring a sense of certainty to long-term investors. When returns in other asset classes seem more unpredictable, the fixed coupon nature as well as the fixed maturity date of an instrument can bring certainty to investors and savers. This is very beneficial to conservative investors. In multi asset portfolios, fixed income instruments also bring the benefit of diversification in portfolio construction.

Let's take a look at why certain fixed income instruments have been included into our portfolios over the last year:

Cash: Short-term yields in SA are attractive given the outlook for short-term rates and the expected inflation profile over the next year or two. The front end of the yield curve in SA is still very steep, meaning investors and savers are rewarded with a high real yield without having to take large amounts of interest rate risk.
Credit: Credit spreads of certain corporate and bank debt seem to be at cyclical highs at the moment. Given the quality and stability of the SA banking system due to the further implementation of bank capital regulations (Basel 3), we believe bank spreads are at attractive levels given the real yield earned and the duration risk taken. The bulk of SA bank bonds are issued in the three to five year area of the curve. We believe investors are being fairly compensated at present for taking the credit risk on large SA banks, including the fact that we have also seen an improvement in secondary market trading of these bonds.
Government Bonds: Bonds remain attractive on a real yield basis, given the credit quality and liquidity. Yields are however trading above our intrinsic value and will benefit from the expected lower inflation profile over the next year. Notwithstanding the selloff in global bond markets during the last quarter of the year, the SA bond market has remained resilient and yields remain anchored around the 9% level on the 10-year bond. On a global basis, SA real bond yields continue to look attractive given our current economic fundamentals and the fact that SA maintained an investment grade rating.

In summary: We keep allocating to longer dated bank NCD's as they remain attractive on a real yield basis given the level of risk and the expected path of inflation and interest rates. SA government bonds also remain an attractive asset class, due to the high real yield being offered as well as the low credit risk and high liquidity factor in these instruments. The outlook for economic growth is expected to improve next year. The prospect of lower inflation is also positive for fixed income. Global macro factors, especially in the US seem to be changing. We will have to see what the longer-term impacts of expected government policy changes from the US are.

We are adding to the bond positions on specific points of the nominal curve where the real yield remains attractive given the duration risk. We remain positive on valuation in specific areas of the credit market. We will continue to search for real yields that are attractive at an appropriate level of risk.

We have maintained equity exposure in counters that offer attractive valuation metrics. We will continue to search for real yields which are attractive at an appropriate level of risk.