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Turbulent markets provide opportunities in fixed income

18 September 2018 Tyron Green, PSG
Tyron Green, fund manager of the PSG Income and PSG Diversified Income funds.

Tyron Green, fund manager of the PSG Income and PSG Diversified Income funds.

Emerging markets have sold off significantly this year, amid sharply deteriorating sentiment towards assets and economies that investors perceive to be risky. This has created an opportunity in inflation-linked RSA Bonds (ILBs), according to PSG Asset Management.

“We’ve been watching this area of the market for a while, but it previously offered an insufficient margin of safety,” says Tyron Green, fund manager of the PSG Income and PSG Diversified Income funds.

ILBs provide a hedge against rising inflation as well as protection against upward inflation shocks. They are issued with a fixed coupon (annual interest rate) on a principal amount (the amount invested by the bondholder) that is adjusted for inflationary growth.

Consider an ILB that was issued for R100 with a fixed coupon of 3%. If inflation in the first year of investment is 6%, it would bring the bond’s total return to R9: a coupon of R3 (3% of the R100 principal) and principal growth of R6 (a 6% inflationary adjustment on the R100 invested). If inflation in the second year of investment is 10%, the annual return will be R13.78: a coupon of R3.18 (3% of the revised principal amount of R106) and principal growth of R10.60 (a 10% adjustment to the revised principal amount of R106).

Green says that ILBs are once again offering attractive real yields. “As their popularity has waned in the wake of deteriorating emerging market sentiment, ILBs have become more attractively priced.”

Prices have fallen along with investment demand and yields have risen. As such, ILBs with longer-dated maturities are now offering real (above-inflation) yields of over 3%, while real yields on shorter-dated ILBs are around 2.8% (shown in Graph 1).

“This is the first time in recent years that these assets have presented a compelling investment case, especially as the high yields available in the early 2000s were on offer to attract investment when the instruments were launched. As a result, ILBs have  been added to our buy list.”

Graph 1: ILBs are offering real yields

Source: I-Net

Green says that PSG Asset Management aims to  construct portfolios that will perform under various scenarios. “We don’t attempt to make predictions and don’t bet on outcomes. Our base view remains that the South African Reserve Bank (SARB) will continue to implement its inflation-targeting mandate successfully, as it has done since the introduction of the policy framework in 2000.” (Shown in Graph 2 below.)

While inflation has seen some upward pressure due to higher wage negotiations, electricity price increases and the recent rand blowout, it is generally still expected to remain within the inflation target band (between 3% and 6%).

Graph 2: The SARB has built credibility in inflation targeting

Source: Bloomberg

Under this scenario, says Green, the fixed-rate instruments in PSG’s fixed income portfolios should continue to offer real long-term returns. As such, the firm still sees opportunity in South African sovereign bonds, fixed-rate negotiable certificates of deposit (NCDs), corporate bonds and bonds issued by select state-owned enterprises.

However, there is also a scenario under which inflation and interest rates rise. In this type of market, floating-rate instruments will outperform their fixed-rate counterparts, and ILBs will outperform traditional bonds. To hedge against this risk, PSG has diversified its holdings by investing in floating-rate instruments, offshore cash and ILBs. “We believe that this best positions our investors to achieve the returns they require over the appropriate time periods, and under a range of possible outcomes.”

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