During the second quarter of 2017, the size of the Stanlib Income Fund increased from R22.5 billion to R23.6 billion. The Fund’s modified duration decreased from 0.58 years to 0.49 years during the quarter due to the volatility in the bond market. Returns in the Fund look attractive compared to money market returns despite the defensive positioning, due to investments in high yielding securities. The concentration to floating rate notes was slightly increased leading with the new inflows.

Looking Ahead

Given the negative political headlines and rating agency actions that characterized the second quarter, bonds performed well with the All Bond Index returning 1.50% during the quarter and outperformed other asset classes with a 4.00% return for the first half of the year.
The cabinet reshuffle at the end of the first quarter, which saw the finance minister and his deputy being replaced, caused the weakness in the local 10 year bond yields to spill over to the second quarter. This was viewed as a buying opportunity by foreign investors, amidst the risk-on environment which benefitted Emerging Market assets, as they increased their local bond holdings by R21bn during the quarter. As a result bond yields rallied to 8.35% before closing the quarter weaker at 8.79% due to market concerns that major central banks will tighten monetary policy conditions quicker than initially anticipated. Though it ended the quarter largely unchanged at R13.10/$, the Rand traded to a low of R12.56/$ during the quarter also on the back of positive EM sentiment. The 5 year SA sovereign risk spread improved from a high of 225 basis points in the quarter to 199 basis points at the end of June in line with peer emerging markets spreads

South Africa was downgraded by the 3 rating agencies in the quarter, with Standard & Poors and Fitch cutting the foreign currency rating to sub-investment grade, and Fitch also cutting the local currency rating to below investment grade. Both Moody’s and Standard & Poors have the local currency rating 1 notch above the sub-investment grade, with the risk that any of them cutting the local currency rating to below investment grade will lead to capital outflows as some of the foreign investors will be forced to sell local currency bonds. This will lead to higher borrowing costs for the government, putting pressure on the already strained fiscal position exacerbated by the technical recession.

In international markets, the US Federal Reserve hiked interest rates by another 25 basis points in the quarter after the seeing the relatively weak inflation and growth data as transitory. The market expects them to increase rates by another 25 basis points in 2017 and to gradually continue to increase rates thereafter.

Fund review

The size of the Stanlib Income Fund was R22.9 billion at the end of the fourth quarter of 2016, compared to R21.7 billion the previous quarter. Returns in the fund look attractive compared to money market returns despite the defensive positioning, due to investments in high yielding securities. The Fund’s modified duration was increased from 0.46 year at the end of the second quarter to 0.50 years due to a higher probability of interest rates topping out as indicated by the SARB. This was achieved by increasing exposure to short term fixed rate instruments funded by sales of floating rate instruments, and investing new cash lows in shorter dated fixed instruments

Looking Ahead

The All Bond Index returned a 15.5% for the year as a whole and 0.4% for the last quarter of the year. This makes the asset class to be the best performing in the South African market. The South African 10 year bond yield ended the quarter at 8.91%, weakening from the last quarter close of 8.67% as the market priced in a much higher probability of the US increasing interest rates, and the impact of Donald Trump winning the US elections. In the end, the US Fed increased interest rates by 0.25%, but also indicated that they may increase the Fed Fund rate by 0.25% another three times in 2017.

The bond market movements over the fourth quarter was largely driven by the selloff of the US Treasuries market, where they tracked higher in response to Donald Trump being elected president of the US, elevating the probability of the FOMC continuing to hike short term rates. US 10 Year Treasury notes sold off aggressively from 1.595% to end the last quarter of the year at 2.445%, thereby causing some jitters in emerging markets. Foreigners who had been increasing exposure in emerging markets in the third quarter of 2016 ended up selling R34 billion of South African bonds in the fourth quarter, as yields traded above 9.20% at one stage. On the positive front, South Africa managed to stave off the threat of a downgrade to junk status by the rating agencies, although Standard and Poor’s downgraded the local currency rating by one notch. As a result the CDS spread ended the year at a respectable 215 basis, after starting the quarter at 260 basis points. The risk of a downgrade to - junk status - will remain on the horizon for as long as GDP disappoints and the political situation takes long to stabilise.

During the fourth quarter, the South African Reserve Bank (SARB) left interest rates unchanged despite inflation still printing above the 6% target level, however, there is growing expectation that inflation will track lower in 2017. Despite the volatility experienced in the local currency, when it weakened to R14.50 in November post the US election, it ended the year at a respectable R13.73. The SARB is expected to leave interest rate unchanged,