Give me the good news

Ian Scott, Head of Fixed Income, PSG Asset Management.

Crocodile Harris, Give me the Good News, 1982.

There is a lot of negative news flow right now

Many South African investors seem to be caught in a place where the only economic, political and thus investment news they are hearing is bad. Turn on the radio – bad news. Turn on the TV – worse news. Braai-side conversations with friends and family are being dominated by a slew of negative perceptions. Emotions are currently very negative, it seems.

But is it really all that bad? Is there really no good news around? We believe that there is and that it can be found in a forgotten part of the market – fixed income.

Fixed income markets are pricing in a lot of fear

There is currently a lot of fear and uncertainty being priced into markets. The weakening of the rand in 2015 and the drought being reflected in higher food prices are both pointing to fears of significantly higher inflation and interest rates over the medium term. Fears are rising that the South African Reserve Bank will have to increase interest rates by more than expected. Whilst these fears are in no way unjustified, we do think that most of this bad news is already being reflected in the prices/yields of fixed income instruments – they have become cheaper.

Yield curves are pricing in a normalised interest rate cycle

We believe that the yield curves are pricing in a normalised interest rate cycle. This means we have become used to rates increasing by on average around 5% in an average of just 13 months.

However, the data we analyse does not support this assumption due to a number of factors which have not been present in recent rate-hiking cycles. These include the weak underlying growth fundamentals currently present in South Africa and other major emerging markets.

The present investment opportunity has arisen from a repricing of risk

The opportunity for investors has arisen from the fact that domestic cash, bond and credit markets have finally begun to price in inflation, sovereign default and credit risks in a way they were not doing three years ago.

Three years ago there were few perceived risks

In 2013 South African fixed income yields were at near-record lows. Back then yields had been driven down by the global phenomenon of quantitative easing, as central banks around the world pushed their lending rates down to create cheap money for companies to borrow and consumers to spend. With deflationary fears dominating fixed income markets, very little risk premium on inflation expectations was priced into fixed income instruments. The environment was such that South African sovereign default risk was very low – as was the credit risk of local companies.

Local corporate failures saw a repricing of risk in credit

In 2014 we began to see domestic markets reprice the risk on corporates after the failure of First Strut and subsequently African Bank. In a short time the risk premium of lending to corporates increased to levels which were much more in line with the credit-worthiness of the individual companies.

2015 was the start of US rate normalisation and a focus on emerging market sovereign risk

During 2015 the US Federal Reserve began to talk about keeping an eye on US inflation. It hinted that it may start to slowly hike its base rate to prevent inflation from taking hold in that economy. This eventually happened in December 2015 when they hiked the rate by 25 basis points.

In the second half of 2015 markets started to reprice sovereign risk premiums in emerging markets as the spectre of a Chinese slowdown began to emerge. The risk premium for South Africa was exacerbated by the fall in commodity prices, weakening of the Rand and Nene-gate.

Bonds are showing more value

The yields of these fixed income instruments have risen substantially from where they were three years ago. This is as a result of all the noise and fear that has been created around emerging markets, the South African domestic situation, inflation, sovereign risk concerns and company-specific credit concerns.

The graph below shows how the SA Bond Yield Curve moved from April 2013 to December 2015:

Source: PSG Asset Management

We believe that some of the fears which are being reflected in local bonds are being overstated and that the risk premiums – some of which have widened to levels last seen just after the 2008 financial crisis – are at high levels.

Margin of safety

We believe the margin of safety in certain parts of the yield curve has widened sufficiently to warrant an allocation in our portfolios. Firstly we saw this happen in the bank funding curve (or the Negotiable Certificate of Deposit [NCD] market) and currently government bonds are a good example. Three years ago we had no government bonds in our portfolios; now we are adding to our bond positions as opportunities arise. The real yields on government bonds have widened substantially given the term or duration risk to hold them in our portfolios.

What does this mean for savers and investors?

We believe that the margin of safety in many parts of the fixed income yield curve is good news for savers and investors as they will be able to take advantage of locking in real (above-inflation) returns at a low level of risk.

Individual investors and savers

Individuals who are saving, investing or drawing income from their investments have a reason to smile if they are invested in unit trusts which are able to generate a real yield that provides income above inflation with the added benefit of liquidity. Money market unit trusts (not to be confused with bank ‘money market funds’) should be able to deliver yields of around 7%. For investors with a slightly longer (0-12 month) time horizon, low risk income-type unit trusts should be able to deliver a yield of around 8%. This is of particular attraction to retired individuals who are dependent on drawing an income from their investments.

Pension funds

Pension funds can now diversify lower-yielding cash in the fund to higher, real-yielding bonds without having to take much more duration risk. This could further be achieved without decreasing liquidity in the fund.

Companies and corporates

Companies and corporations can earn a real yield on cash whilst still being able to get their cash back at 24 hours’ notice by investing in a money market unit trust. As with individuals, they can also benefit from a higher yield in income-type funds should some of their cash have a longer time horizon before it will be needed.

Conclusion

There is a lot of bad news out there, but it’s been factored into the yields of fixed income assets. We believe that the risks to investors have been accounted for – possibly over-accounted for – and that the risks of incurring capital losses from many of these investments are low. There are opportunities for savers, investors, pension funds and corporates to benefit from these yields by investing in appropriate unit trusts.

That is the good news.

The PSG Angle is an electronic newsletter of PSG Asset Management.