The outlook for fixed income

Rashaad Tayob, Portfolio Manager at Abax and Manager of the Nedgroup Investments Flexible Income Fund, comments on the outlook for fixed income funds.

One of the positives we can take from the current crisis is that we’ve been used to living with uncertainty and volatility for a very long time. The current political instability, health crises, high unemployment, racial tension and budget concerns being faced by the entire world are all issues that we’ve been dealing with for the last two decades. We are, therefore, perhaps a bit more prepared.

Looking for the ‘income’ in fixed income funds

For developed markets there is no income. It’s only the fixed component that’s relevant for them. Germany’s risk-free government bond yield dropped to zero in 2011, followed by negative yields in 2014. The US, with the dollar being the global reserve currency, attempted to escape the debt trap that has engulfed Europe and Japan by normalising rates. The US risk-free government bond yield made it to 200 basis points and tried to unwind the balance sheet by about $300 billion. This ended up stalling the economy and tanking the market, forcing them to reverse course in 2019. The US started cutting rates well before the COVID-19 crisis and income began to disappear in the developed world at least a year ago. The combination of global negative rates and pressure from the US President wanting lower rates, resulted in the US capitulating and bond yields are now back at zero and forecast to remain that way for a prolonged period.

Impact of high debt levels

Low interest levels are as a direct result of the excessive global debt levels. In the decade leading up to the financial crisis in 2009, there was a massive increase in global debt driven by households and financial institutions. Post this crisis, governments and non-financial corporations increased their levels of debt too. Post 2009, the world needed lower rates to stem a financial crisis. Unfortunately this encouraged more risk taking and an increase in debt build up. In the last five years, corporates have increased their leverage massively. We are now forced to keep interest rates low, because any attempt to increase them, given this level of debt, will cause a downturn in the economy and we risk some kind of depression. It’s going to be a very difficult and volatile period going forward.

Yields in South Africa

South Africa is fortunate in that there is some yield left in the South African market. The SARB has cut rates aggressively taking the repo rate down to a record 3.75, enabled by the global situation. The 10-year SA government bond yield is back at around the 9% level, which with 4% inflation is a real yield of 5%.  However, this 9% yield comes with an unprecedented level of risk. The solvency risk in South Africa has never been higher and we entered the COVID-19 crisis with high levels of debt. In 2007, the level of debt to GDP ratio was around 25%. We’ve allowed that debt to increase dramatically over the last decade. Pre-COVID-19, we delivered a budget deficit of 7% for 2020 and 2021 with our debt trajectory heading towards 70% debt to GDP ratio over a 3-year horizon. This is a very precarious position to be in as an emerging market from a solvency perspective. Thanks to COVID-19, we’re going to be running more than a 10% budget deficit while GDP is falling. Over the next 3,5 years, South Africa is heading to a 100% debt to GDP ratio. If you add in the SOEs of another 20%, we’re at 120% debt to GDP ratio over the medium term horizon, placing us firmly within a debt trap. The only comforting factor is that the rest of the world has joined us.

Escaping the debt trap
You cannot grow unless you cut the level of debt and there are only two options. You can either restructure the debt or attempt to run a higher level of inflation in order to reduce the real value of debt over a period of time. The latter has historically been the path of least resistance. Inflation has remained under control for the last few years at between 4% and 5%. We believe that inflation is likely to dip quite severely in the near term, close to the 2% level, partly due to a lack of demand but also due to technical factors where it’s very difficult to measure inflation in a lockdown. The South African government as well as the rest of the world will try to run a higher level of inflation in order to escape the debt trap.

How will portfolio construction be impacted?
Our Flexible Income mandate is run with the philosophy of diversified alpha, where we look for the broadest possible range of fixed income assets and strategies that allocate the risk to different types of fixed income assets. A diversification mindset is even more important given the level of uncertainty and volatility that will materialise over the next few years. We’ve got allocations to cash, floating rate notes, bonds, inflation-linked bonds, preference shares, local convertible bonds, local property, offshore property, offshore money market, offshore convertible bonds and domestic bonds. Going forward there is going to be even more emphasis on diversification and trying to balance the risk given the potential range of outcomes. We recently increased the level of inflation-linked bonds and both offshore and domestic convertible bonds in the portfolio. With the widening of credit spreads, we’re seeing more opportunities to add credit exposure. The portfolio is well placed despite being in a low return environment and the repo rate at record low levels. We constantly look at the potential return versus the potential risk and focus on diversification and this will be more important now than ever.

The Nedgroup Investments Flexible Income Fund has, for the past ten years, been held in the enhanced cash part of a number of Nedgroup Investments’ portfolios. It’s been a consistently good performer achieving 8.1% per annum since inception relative to the benchmark of 6.5%.

To listen to this conversation, go to Nedgroup Investments Insights on Apple Podcast, Google Podcast and Spotify.