Why bonds are an attractive option in uncertain times

Jannie Leach, head of core investments for the Nedgroup Investments Core Bond Fund, sheds light on why bond funds are an attractive option in uncertain times.

The Core business has grown quite rapidly over the last few years. We currently have over R33 billion in assets under management (AUM). A lot of that was due to dramatic market corrections in March. The funds have built up solid track records and we have the largest passive or rules-based fund in the country, our Core Diversified Fund, sitting at just under R14 billion AUM.

What differentiates the Core Range from its peers?

A lot of our funds started out as partnerships with fund managers, financial advisors, behavioural specialists, etc. We focus on designing investment solutions that fit within a financial planning environment. Our design takes investor behaviour, portfolio implementation and risk management into consideration to ensure investors make sensible investment decisions and get the big picture right.

Why bond funds?

The majority of investors in the past made use of multi-asset income funds, with bond funds mainly used by multi managers as a building block within a portfolio for diversification relative to equity. On rare occasions they were used as a stand-alone fund for yield or income. What is appealing now to advisors and clients is the attractive yields they are offering of over 10% or inflation plus 6%, which is a good long-term yield. This is partly due to Moody’s downgrading and the poor economic conditions in South Africa over the past few years. Bond funds typically distribute their income on a quarterly basis so can be used within a living annuity structure as steady quarterly income. One needs to remember that bond funds are more volatile than money market funds although the income distribution remains reasonably constant. Bond funds typically experience a lot of capital volatility and therefore require a longer time horizon.

Nedgroup Investments Core Bond Fund - overview

The dispersion between the returns of bond funds is extremely small. The vast majority of bonds over the past 7 years (excluding the best and worst performers) were within a dispersion of + or -0.6% pa of the average, which is a very narrow range compared to equity funds, which have a dispersion of over 3% pa. Our philosophy when designing the Core Bond Fund was to achieve superior, risk adjusted returns relative to its peers with lower fees while staying largely neutral on a modified duration. The Core Bond Fund charges a fee of 0.35% pa with a total expense ratio of 0.45% pa. The combination of low fees and being neutral on duration should result in top quartile performance over time. The fund has achieved scale and currently has R1.8 billion AUM. As the peers hold credit we also take sensible exposure to credit, currently it makes up about 17% of the fund. Taquanta uses patient and tactical approach to implementation by balancing tracking error versus the cost of trading. This is especially important in the bond space where we often have to deal with illiquidity in some of the bonds.

Determining the duration of the peers

Taquanta uses the daily price movements of the vanilla bond peers (excluding Multi-manager, Index funds and ILB funds) to determine the peers’ average duration. This is not an exact science but generally bond managers don’t increase or decrease their duration too frequently, so there’s more than enough time for us to start allocating and move the duration of the fund if required. As more peers start increasing their duration, this will become obvious given the monitoring and tracking that is done on a daily basis.

Taquanta’s implementation value add

Taquanta tend not to invest in basket trades, which can result in giving away a lot of yield, but rather follow the approach of buying one or two bonds with the desired duration so we don’t give any yield away. They also use spread trading to deal with the lack of liquidity in bond markets. As this is expensive, it requires patience and again, balancing tracking error versus the cost of trading. We prefer to make use of agency brokers as opposed to principal brokers as this gives us better price discovery than trading directly with banks. We monitor how bonds have performed versus fund positioning on an absolute and relative basis, every day.

Portfolio holdings

The credit component of the funds is quite small, with the vast majority of the allocation in SA Government bonds (75.3%) and a small allocation to our Core Income Fund. The vast majority of bonds are of a longer duration, 45% greater than 12 years. The fund’s current duration is at 5.62 with a yield of 10.9% before fees. This is quite an attractive yield from a long-term perspective.

The Core Bond Fund has delivered on its strategy if we look at returns over the shorter term where it outperformed its peers by about 2.5%. This was helped by receiving new inflows in the portfolio over the time that bond markets fell. Over 7 years, it was the second best performing fund out of 13 peers and third best performing fund relative to all other bonds.

A big advantage of the fund is that it is very competitively priced, doesn’t take any bets in terms of duration versus its peers and is sensibly implemented. There is increased interest in bond funds at the moment because of their attractive yields.

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