Navigating South African Fixed Income Markets

Philip Liebenberg of Abax Investments is the incoming Portfolio Manager for the Nedgroup Investments Flexible Income Fund.

In light of the impending Budget Speech, Philip shares his view on the current market dynamics and the strategies in the Fund, which can add value to investors towards achieving a cash plus return.

To listen to this conversation, go to Nedgroup Investments Insights on Apple Podcast, Google Podcast and Spotify. Click here to watch the recording of the conversation.

Given the low money market rates, it’s important to have a fund with a wider opportunity set. We follow a diversified alpha approach with many fixed income investment opportunities, including bonds, credit, preference shares, convertible bonds, property, etc.

Bonds – the positives and negatives
Bonds are quite topical at the moment with our 10-year bond close to 9% and money market yields at about 4%. We’ve had quite a few positives in the short term. Over the last couple of months, tax revenue and tax receipts have improved significantly. This was driven mainly by the corporate sector, specifically mining where there was a rebound in mining exports in the second half of 2020 and commodity prices shooting the lights out. When commodities do well, the Rand does well.

We have a revenue overrun of at least R50bn, which means that the 2020/21 budget deficit will likely be closer to a 13% deficit and not the predicted 15% deficit. In terms of expenditure, government decisions have been more prudent and have kept largely to their MTBPS target. The public sector wage bill issue is ongoing.

Globally, there is massive fiscal stimulus and lots of liquidity, which is driving a lot of what we’re seeing in asset prices. There is a possibility that we could cut bond issuance by R2bn a week given the revenue overrun. The local bond issuance has more than doubled in the last 3-4 years and is why we need fiscal consolidation and to stabilize our debt to GDP ratio, which is heading towards 95% by 2024/5.

The restructuring of our debt and some reforms being forced onto us is not impossible down the line. We’ve got a massive mountain of debt with debt service costs ballooning, which need to stabilize. We are linked into the global financial system and at the moment are beneficiaries with commodity prices doing well and risk on trade. But, we have seen US treasuries creeping up and down the line this could unhinge the fantastic rally that we’ve seen. As we saw over the last week, when global bond yields and treasuries rise, it has a knock-on effect on our local markets. Our bond yields are about 9% with the money market at about 4% and REPO at 3.5%. We don’t have more bond exposure in the Nedgroup Investments Flexible Fund because of the risks and won’t have overall duration (interest rate sensitivity) of more than 2years in our fund. Bond yields still give a real return of about 5% and inflation seems to be under control, although globally it’s beginning to be a concern for the market. If one looks at the weaker dollar and high commodity prices, the threat of higher and unexpected inflation is real and is why we’ve increased the Fund’s inflation-linked bonds component to about 2.5%. We like this kind of bond as it protects the real value of capital and is a fantastic diversifier.

Interest rates
The SARB quarterly model sees rates stabilizing and going up over the medium term. This is not our view and think we will probably see rates staying lower for longer. With the current threat of inflation and higher commodity prices, the next move in rates will possibly be up.

Offshore exposure
It’s important right now to have the ability to invest offshore. The Rand on a Purchasing Power Parity basis looks fairly valued. If you adjust it for our debt dynamics and fundamentals, we think it’s slightly expensive. The Rand has staged a fantastic recovery from it lows against the dollarin 2020 and the RAnd made back most of its losses compared to our emerging market peers. We do, however,see the Rand as slightly overvalued at these levels of R14.50. 

Fund positioning
JIBAR 3-month rate (short term interest rates) is quite low at about 3.6%. The current Fund yield is about 5.8%, so we’re getting quite a nice pick-up over money market funds. In South Africa we have been spoiled with high real money market rates, which might be something of the past. This is where having a fund that can access diversified income opportunities is important to manage income levels.

Portfolio allocation
Diversification is key and we want to be able to look at opportunities across the income space, which includes preference shares, convertible bonds, offshore bonds, floating rate notes, etc. We increased our allocation to inflation-linked bonds and took advantage of some interesting convertible bond opportunities. The Fund yield is about 5.8% with total duration of 1.6. Of that, 0.7yr is in SA nominal bonds, 0.5yr in SA inflation linked bonds and 0.4yr in offshore bonds. We have an effective offshore net exposure of 9%, which is a nice counterbalance to our local nominal bond exposure, a good diversifier and speaks to our view that the Rand is slightly overvalued at these levels.

What levers are used in the Fund to balance risk?
Offshore exposure is critical and is a natural hedge against sudden, big sell offs in the local bond market. The Fund’s total offshore exposure is about 18%. 9% of that is hedged back into Rand. This is important because we do get offshore opportunities where we can buy a quality local company that issues offshore with a yield of about 2-3%. When you hedge it back into Rands, you can add another 5% on yields, so can get anything between 7-8% in Rands. If you had to buy that exposure locally, you would get a lot less.

These are some of the levers we use to lock in higher yields for the Fund. We have some offshore convertible bonds where you can pick up a convertible bond with a 1-2% yield and get the upside if the equity does well. We have a small allocation to Twitter where we were able to make good gains in this way. This is an area that we want to expand going forward and widen the investment universe slightly, but within the mandate of the fund.

Success with Royal Bafokeng convertible bond
Royal Bafokeng has been a decent position in the Fund and has done extremely well, nearly doubling since we bought it. We are now reducing this exposure.

What role does position sizing play?
As an income fund, position sizing is important as you don’t want to have big exposure to any one counterpart. Risk management and position sizing are key inputs into portfolio construction.

Is property still a challenged area of the market?
We have an exposure of about 2.5% to property through a basket of SA property companies with a focus on quality, so low LTVs, strong balance sheets and some of the more liquid counters. While there is risk involved, you have to see at which point you get compensated for this risk. We added to our property exposure at the end of 2020, which worked well for the Fund. We have a nice mix of property. Equites is a logistics company, which has done very well so we have tried to diversify away from the usual big exposures.