Ever since central banks in many parts of the world dropped interest rates close to zero, the search for yield has been a persistent investment theme.
As real bond yields have turned negative in most developed markets, investors have had to find alternative sources of income. This had led to concerns about having to take on greater levels of risk to secure a return.
This has not, however, been a concern for local investors. Real interest rates in South Africa have been high, and cash has been a relative out-performer.
The South African Reserve Bank’s (Sarb’s) sudden and sharp reduction in interest rates in response to the Covid-19 crisis, together with the country’s broader economic weakness, has however affected the fixed income market substantially.
‘The search for yield is a concept that normally is isolated in developed markets,’ said Peter Kent, co-portfolio manager of the Ninety One Diversified Income fund. ‘In my investment lifetime I wasn’t expecting it to come to South Africa.’
The only option
While Kent noted that this observation is somewhat tongue-in-cheek, since cash rates are still above 3%, the dynamic is nevertheless relevant. With the income from cash now considerably lower than it has been over the past few years investors needing an income are increasingly forced into the bond market.
‘The yield in government bonds is there for a reason,’ said Kent. ‘It’s there because with a budget deficit of 15% of GDP, the government has to entice people. It’s crowding out all other investments by offering a yield commensurate with the risk.
‘That is the problem with bonds. You can look at the fiscal situation and the local economic situation, but the only investment in South Africa is yield because they are cannibalising all of the other investment in the country.
‘So, in a South African context I don’t think bonds are wrongly calibrated for the risk,’ said Kent. ‘The reason the yield is so inflation-beating is because of the risk.’
In this environment, income fund managers have to think carefully about what they are taking on in their portfolios to generate reasonable levels of return.
‘There is not one place to hide in yield,’ said Kent. ‘They all have a little capital risk attached to them.’
The duration in Ninety One Diversified Income fund is currently just over one year, with a yield of around 6.75%. About 80% of the government bonds in the portfolio are nominal bonds, with 20% allocated to inflation-linkers. This is despite Ninety One having high conviction that inflation will remain subdued in the short to medium term.
‘It may seem a little odd given our inflation view, but short-dated inflation-linkers are offering real yields of close to 4%,’ said Kent. ‘For us, that is just a nice real yield in the event that our inflation thesis don’t work out.’
To mitigate some of the local bond market risk, the portfolio has an offshore allocation of near to 10%. While many managers have felt that the developed market yields are too low to justify any exposure, Kent sees this as vital.
The fund often runs a little more duration than most of its competitors, while also finding positive yield in investment-grade credit and listed property.
‘We usually have those as our income-generators and then, to protect ourselves, we have a little bit of offshore exposure,’ said Kent. ‘That little bit of listed property and bond yield is more than enough for the negative carry of the offshore position.’
Usually, that carry is around 6%. At the moment, however, it is far lower than that as local interest rates have come down so far.
‘It’s never been cheaper to have that offshore protection in the portfolio,’ said Kent. ‘The negative carry has never been this in favour of having offshore assets.
‘If the execution of the budget doesn’t work, if any of the risks in the bond market materialise, if the US has a second peak of infections – all of those are ultimately going to manifest in the currency,’ said Kent. ‘That makes offshore a fantastic hedge at very little cost.’
The fund’s international exposure is, however, not exclusively in dollars due to the risk that the US currency could weaken sharply given the level of monetary stimulus from the US Federal Reserve. If the US economy recovers more quickly than expected and US consumers start spending and flood the world with dollars at the same time that the Fed is printing money, that could have a significant impact.
‘Our exposure is diversified a little away from dollars because we do worry about what the dollar will do given what the Fed is doing,’ said Kent.