Flexible Income Fund – Maintaining the course in challenging times

One of the asset classes that surprised us all again last year was the fixed income sector. Rashaad Tayob from Abax Investments, Portfolio Manager for the Nedgroup Investments Flexible Income Fund, explains how they achieved the Fund’s performance in 2020 of 5.7% versus the 4.95% cash equivalent benchmark and the team’s current thinking on the sector. He also illustrates the importance of maintaining the course irrespective of the current environment and how this feeds through to the consequential portfolio structure.

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2020 market performance contributors
The Rand ended the year 5% weaker against the US Dollar. Compared to its worst depreciation of 40%, its recovery was phenomenal. Cash delivered 4.5% as the Repo Rate and JIBAR were significantly cut to boost the economy. Inflation linkers delivered 4.2% as their yields re-rated higher, which had a negative impact, but they did recover towards the end of the year. We increased our exposure here from about 4% up to 15%. The All Bond Index ended the year with an 8.7% return, which masked the 15% drawdown that materialised in March/April 2020 with more than 20% in its worst period. We bought into that weakness enabling us to deliver a nice return. The poorest performing sector was the SA Property Index with a 40% drawdown following on from a poor year in 2019. Given the issues in the economy and banking sector, SA preference shares were down about 11%.

Portfolio performance
The portfolio had a gross return of about 6.4% for 2020. Our strategy was a diversified alpha approach, which aimed to get returns from a mix of different asset classes and diversifying across the fixed income space. Performance was a function of offshore returns (1.4%), SA cash (0.9%), floating rate notes (1.1%), SA Linkers (1.3%) and SA Bonds (2.8%). We have been quite cautious with property, which is less than 2% of the Fund and also our biggest detractor at -0.7%. Preference shares, where we had 3% exposure, fell quite significantly, inflicting a -0.4% return on the fund.

Money market and bond yields
2021 is a bit of a conundrum. The repo rate has been cut from 7% to 3.5% with JIBAR sitting at 3.6%. In terms of the core portfolio where we’ve always had JIBAR-linked floating rate notes that have delivered between 100 and 200bps, they are now delivering returns of 4.6% - 5.6%. So while we have a low level of credit risk, the return has shifted fundamentally lower given that rates have been cut aggressively. While you can still get 9% returns on the 10-yr bond, the gap between the repo rate and the 10-year bond is very wide by historical standards. The risk is materially higher now with an 80% debt to GDP ratio compared to 10 years ago where we had a 40% debt to GDP ratio. Where we add bond exposure, we do so within a risk control framework by adding linkers, looking for hedges and increasing our FX exposure. We do think there is an attractive component to bonds, but you need to be aware of the risks.

SA’s precarious debt position and the bond take-up
Our debt levels have increased dramatically since 2012 and a gap has opened up between SA and our emerging market peers. The US and SA piled on the most debt during the 2020 crisis and are both suffering the consequences. The reality of debt accumulation is that you have to issue a lot of bonds and someone needs to buy them. Since 2012, we’ve issued R100 - R150 billion of bonds per annum. At the moment, we are at a phenomenal run rate of R450 billion per annum of bond issuance and it’s difficult to see how the market can continue to absorb it. While across the spectrum there has been an increased take-up of bonds, it is beginning to crowd out the investment industry in SA and it will be difficult for the local savings industry to continue to absorb that amount of bond exposure.

Around the world, central banks have bought up the bonds, but not South Africa. The SARB had about R8m of SA government bonds on their balance sheet, which they increased to R40 billion during the crisis. Since the volatility and the crisis have abated they have not added to that. They’ve allowed the market to determine the fair value of the bond yields and that’s why we have one of the steepest curves out there. But, is it sustainable for the government to be funding at yields of 9%-10% with an 80% debt to GDP ratio? We have two options. Either we have fiscal restraint where Treasury delivers credible budgets and lower budget deficits or the SARB will be forced to bring bond yields down through intervention, which will result in a weaker Rand.

Inflation-linked bonds can protect the real value of capital
Inflation-linked bonds is an area where we’ve seen a lot of value. We had 4% exposure going into the crisis and when yields were close to and above 4%, we added about 10% to the portfolio taking our exposure up to 15%. Yields have come down to about 3%, but we think they present an attractive investment from a risk return perspective.

Portfolio positioning
Going into 2021, as we recover from the Covid crisis, we are faced with a potential debt crisis. Our strategy is to have a diverse portfolio of fixed income assets in order to generate a cash plus return without introducing a high level of downside risk. We have a large component of floating rate notes (32%), fixed rate bonds (18.8%), inflation-linked bonds (15.6%), convertible bonds (2.4%), preference shares (2.6%), offshore property (0.1%), offshore bonds (12.2%), offshore money market (6.2%), SA property (2.5%) and SA money market (7.7%). We’ve maintained a high degree of credit quality, increased our allocation to inflation-linked bonds and taken advantage of convertible bond opportunities. The Fund’s estimated gross 12-month projected yield is just over 6.1% with a low level of downside risk and a duration of 1.5 years. This is spread out over 0.65 year SA Bonds, 0.5 year SA Inflation Linked Bonds and 0.35 year Offshore Bonds. We’ve increased our offshore net exposure from about 4% to 8.5%.