How to enhance low cash yields

Philip Liebenberg is a Portfolio Manager at Abax Investments, the managers of the Nedgroup Investments Flexible Income Fund. Philip takes us through some of his strategies to manage the risks in the markets and how the Fund is positioned to outperform cash.

Contributors to the fixed income asset class performance

The Rand was a fantastic performer over the year with a gross return of 25.4%. We saw a sharp rerating of fixed income assets albeit from a low base. SA inflation linked bonds and the All Bond Index returned 16.7% and 17% respectively with property returning 27%. Q1 2021 was interesting with inflation linked bonds returning 4.6%, but a negative return of 1.7% for the nominal bond market. The quarter will be known as the reflation quarter where global inflation fears got hold of the market, value outperformed growth, yields increased, but you made losses on value. If you had stayed invested, you would have done well over the last year.

Contributors to the Flexible Income Fund’s performance

The Fund returned 11% (gross of fees and investment costs) for the year. There was a strong rebound in bonds contributing 7.6%, most of which came from convertible bonds. We had a very good quarter with a return of 2.3%. A big contributor was our exposure to convertible bonds. Our diversified approach paid good dividends for the Fund.

Diversified approach

The investment objective of the Flexible Income Fund is to generate a return above its cash/money market benchmark return (110% of the STeFI Call Index) with a high degree of consistency and with low capital volatility. The Fund achieves this by looking at the whole universe of available fixed income assets.

Yield curve

Money market returns at about 3.5% are barely beating inflation. The nominal bond market is achieving yields of 9.4%, which is appealing. We see nominal bonds as being fairly valued and we have a good diversified exposure to them. Nominal bonds are not without risk if you look at the local fiscal situation. Over the next 5 years, the market indicates that inflation will be around 3.5%-4%. We think inflation will be higher and therefore have inflation linked bond exposure to the front end of the curve. Our nominal bond exposure is towards the 10-year area of the curve and have rather chosen to protect against inflation through an offshore allocation (higher SA inflation should result in a weakening ZAR versus the US dollar.)

Inflation linked bonds

Global governments have got tons of debt and one of the ways to get rid of it is through financial repression by making sure that savers earn negative real rates on their savings and investments and via inflation. We like to protect the real value of capital, such as through opportunities in convertible and inflation linked bonds. We added inflation linked bonds last year at levels of around 4%. Our preference for real assets in the Fund remains. With a diversified income fund you can hold some nominal bonds, which we do.

ZAR vs USD

Who would have thought that the Rand would be at R14.20 to the USD? The Rand is notoriously difficult to predict. On a purchasing power parity basis, we think the Rand is fairly valued at about R15, but taking into account our fiscal situation and debt dynamics, fair value is probably north of R15. Our current effective currency exposure is at about 8%. The Rand relative to its EM peers has been a powerhouse over the last 8 months on the back of massive global stimulus. The Rand is also a proxy for risk and EM and has been a big beneficiary of this flight to anything with a yield and risk-on trade.

Fund yield pick-up

Our objective is to outperform cash on a consistent basis with a high degree of stability. Through the quarter, the question was ‘what could upset the apple cart when it comes to SA bonds?’ With global growth returning quite quickly, there is a fear of inflation and we’ve seen global bond yields ticking up. If inflation gets more sticky and unexpected, global bond yields could upset the apple cart. We saw a massive rotation from growth to value in the last quarter as well. I believe if you look at global breakeven inflation, especially the US where breakeven inflation is 2.3%-2.5%, it may be slightly overblown. We have struggled to get inflation into the system for more than a decade. This time is different because of the massive fiscal stimulus where money is hitting Main Street and not Wall Street.

Portfolio positioning

The Fund’s strategy is to focus on diversification and to maintain a high degree of credit quality. We have increased our allocation to inflation linked bonds and took advantage of convertible bond opportunities. 22% of the Fund is invested in SA floating rate notes, 20% in fixed rate bonds, 15% in inflation linked bonds and 2% in convertible bonds. Our net offshore exposure is just over 8%. The Fund’s estimated gross 12-month projected yield is 5.7%, which is a nice pick-up over typical money market funds.