Cash management during a pandemic

Sharika Salie is a Portfolio Manager at Taquanta Asset Management, the managers of the Nedgroup Investments Core Income Fund. The Fund is a low-risk fund for investors with a very low risk tolerance who can’t sustain a drawdown in their fund over 1-3 months. Sharika discusses how she managed and positioned the Core Income Fund during 2020 to outperform cash.

Key themes of 2020

SA was caught in the midst of a severe liquidity crisis in March 2020. Globally and locally, assets came under huge strain as the virus spread around the world. R3 trillion of value was wiped off the JSE market cap in Q 1 2020.

In Q2, the SARB cut rates by a further 150bps to provide relief to businesses and consumers. In addition to several liquidity support measures, the SARB offered the banking sector support in the form of regulatory capital relief. As the lockdown played out, piles of cash started to accumulate with banks due to the lack of economic activity and increased savings. At the same time, the SA collective schemes industry saw R68 billion of new money enter this market with record investment into interest bearing unit trusts. In Q3, the SARB provided economic relief again with a 25bps cut in July.

During this time, the market also began to feel the effects of the excess cash in the system. Banks were sitting on large cash balances while R68 billion had entered the CIS market looking for assets to buy, of which there were not many. This demand and supply imbalance sent credit spreads into a freefall. Despite the volatility in 2020, the Core Income Fund experienced no negative months and continued to outperform its benchmark, the STEFI Composite Index. This was largely due to the careful management of counterparty, instrument, interest rate and liquidity risk.

Matching risk and return

The longer your investment time horizon, the more alpha we can generate through the extraction of the liquidity risk premium. As investment horizons get longer, cash flows become less volatile and you get a higher premium. Term premium is the difference between what you get for locking up your money for an extended period and what you get if you kept it in a short-term instrument. Because the future is uncertain, investors get rewarded the longer they invest. Liquidity risk premium is the additional yield that investors should demand for less liquid instruments.

Many investors think that all bank debt is the same. Banks offer several types of debt with different liquidity profiles and levels of capital risk. The type of risk we buy into the Fund is senior ranking debt only, which is not loss absorbing and won’t be called on by banks to stabilise itself. The higher the return, the higher the risk. For the same level of credit, interest rate and liquidity risk, you can’t magically get a higher return, so it’s important to understand where your returns come from. Banks fare better in uncertain times and are less volatile than other types of credit.

The evolution of bank spreads throughout the pandemic

Credit spreads in the local market have been tightening since 2017. This, however, turned abruptly in March 2020 as SA went into lockdown and fear gripped the market. The Fund was sitting on higher levels of liquidity going into the crisis. Market liquidity dried up completely towards the end of March. The only instrument that you could trade to generate liquidity was a vanilla bank NCD. As uncertainty grew exponentially from mid-March, bank spreads widened significantly. The Fund benefitted from this as we purchased bank NCDs at favourable spreads. Towards the end of May, market spreads declined rapidly due to the complete lack of demand for credit in the economy. From August into late November, investors were not being rewarded for the risk they were taking as a result of the supply and demand imbalance. We had to look for alternatives to bank paper and started to turn to treasury bills, which were paying in excess of 50bps above where the banks were issuing.

Opportunities in 2020

Despite muted bank spreads in Q2/3, there was acceptable alpha in SA government bonds. One solution that we implemented to enhance yields was to structure the R186 government bond into a floating rate, low duration, fixed income instrument that paid a significant premium over bank paper.

Outlook for 2021

The expectation is for short-term interest rates to recover from current levels. The key driver will be the recovery of global inflation cycles. Expansionary global fiscal policy and the lifting of lockdown restrictions are set to be growth positive, especially coming off a low production base. A successful vaccine rollout programme and strong immunisation should improve economic activity. In the short term, we foresee that a resumption in economic activity will outpace spare capacity as global demand for final products looks to outweigh the supply of capital goods. As a result, global oil prices have already increased by 37% in Rand terms in Q1 2021 while electricity costs are set to rise by about 16% in the second half of the year. A build-up of global savings from the rise in cash investments is likely to decrease as policy and political expectations become more certain. This decrease in savings should benefit production assets, improve capital expenditure programmes and increase labour participation rates down the line. Our short-term interest rate outlook is that rates will stay low, but will increase at some point towards the end of the year or early next year. The current weighted average spread of the Fund is likely to be maintained in 2021 and rate hikes bode well for the yield going forward due to the Fund’s low duration. We will continue to focus on high quality, investment grade corporate issuers.