Talking about the market, and especially fixed income

Sasfin CIO Arno Lawrenz on duration management, credit risk within funds, the public-sector wage bill, and finding the high-yield/reduced volatility sweet spot when it comes to income funds.

RYK VAN NIEKERK: Welcome to this Market Commentator podcast. It’s my weekly podcast where I speak to the leading investment professionals in the country and we try to get some insights into their perceptions of the market, as well as what they are buying and selling.

My guest today is Arno Lawrenz, the chief investment officer at Sasfin. He has been in this position since the beginning of the year when he succeeded Philip Bradford. Before Sasfin he was the head of fixed income and global investment strategist at Ashburton Investments. And prior to Ashburton he was at Coronation, where he launched the Strategic Income Fund, which at the time was the first flexible-income fund in the country. He later founded Atlantic Asset Management, which was sold to Ashburton a few years later.

Arno, thank you so much for joining me. You joined Sasfin at the beginning of the year, and it has been a rollercoaster of a year so far. How did you find the investment approach at Sasfin when you came there, and have you tweaked it a bit subsequently?

ARNO LAWRENZ: Thanks, Ryk. It’s always good to be back and chatting again. I think the fact that there were Raging Bull awards for performance, both outright as well as on a risk-adjusted basis, tells you something about the investment process. Certainly when I joined Sasfin my role was really to ensure consistency of process and outcome. I think what we’ve seen over the course of this year hopefully is a testimony to the fact that, with the help of the team that we have, we are better enabled to keep going in terms of the performance side of things.

RYK VAN NIEKERK: You became the chief investment officer and you have to manage or lead a bunch of award-winning fund managers. It’s an interesting dynamic. Did you jump in and get your hands dirty?

ARNO LAWRENZ: Yeah. Certainly one of the things has been that I’ve spent many years of my life in the fixed-income space, as well as [being] an expert on the global multi-asset space. In terms of that I think it was important for me to be able to bring some of those insights into the decision-making process. But again, what we’re trying to do is to build a core team of investment professionals so that again, hopefully one day when I’ve worked myself out of a job, the team continues and continues delivering at a high level. I think that really is what excited me. Why I joined Sasfin was precisely because the role that they asked me to play was to build that team and that capability. So it’s a very exciting time for me.

RYK VAN NIEKERK: Are there significant differences between the inner workings of different asset managers?

ARNO LAWRENZ: I’ve worked at a good number of them now. You mentioned Coronation and, subsequent to that I was at Old Mutual. I started the boutique asset management in terms of Atlantic, and there was Ashburton. So I’ve been at the very small and the very large; certainly there are differences – I think overall within the investment industry, [there is] a high level of talent; high levels of insight.

There are many people across the industry that I have a great regard for in terms of competitors and the decision-making processes, and there are various levels of bureaucracy as well, especially in the larger ones. But they’re there for a reason because of the size at some of these companies. I think where Sasfin fits in is somewhere in between, in a way.

I think the way we like to position ourselves is as a boutique with a brand. You have the nimbleness and the flexibility in terms of decision-making, but the brand does mean that there’s something to protect, and there is a system of governance and risk oversight that takes place within the organisation. It’s that combination for me. In a sense what I’ve seen at Sasfin is that there’s that sweet spot where you almost get the best of both worlds in a way.

RYK VAN NIEKERK: How big is your team?

ARNO LAWRENZ: Well, if you’re thinking about the broader team in terms of the analysis side of things, obviously there’s the broader Sasfin team. I actually do not know the number of analysts in total that cover[s]. Again, on the fixed-income side of things, I’d probably say there are four guys and ladies as well, if I can add that in – not just men – who are focused on the fixed-income side of things.

RYK VAN NIEKERK: Arno, let’s talk about the market and especially fixed income, which is your speciality. I’ve seen several of your funds. You’ve really performed well over the past year. For example, I can see the High Yield Fund has returned 9.25% over the past year, which is significantly higher than the benchmark, which was 3.5%. And also your Flexible Income Fund, which is close to an R8 billion fund, has yielded over 11% over the past year. What has your approach been to fixed income, and what is the risk profile attached to those yields?

See the fund fact sheets:

ARNO LAWRENZ: Just to differentiate between the two funds – the High Yield Fund is what we would call a ‘floating rate’ fund where, generally speaking, as interest rates fall you are going to see the yields on that fund fall as well. We make use of quite a bit of credit within the fund in terms of corporate bonds and so forth. So generally speaking that would be linked to typically the three-month Jibar [Johannesburg Interbank Average Rate] rate, whereas the Flexible Income Fund is more, let’s call it, an asset-allocation type of fund within the fixed-income space. So it can invest in inflation linkers, it can invest in fixed-rate bonds, it can invest in floating rates, and so forth.

In terms of the success of these two funds, if I touch on the High Yield Fund, there’s a core of assets which has delivered that base three-month Jibar rate that we call it, plus a margin. We’ve also added some additional securities which typically would be structured around that, taking advantage of the steepest yield curve.

And then in the Flexible Fund – which obviously is our biggest fund and has actually just gone over R8 billion this week – the key there has been perhaps two things that I’d highlight. The one was the active duration management. So again, you have this flexibility, if you are pessimistic or bearish about where bond deals are going in South Africa, where you can cut the duration down to fairly low levels. Or, if you think that bond yields are going to rise, you can increase that duration. I think we’ve done that quite successfully during the course of this year. We started out fairly low. Then we saw, remember, at the beginning of the year with Joe Biden coming in [as US President] and his promise of this massive fiscal stimulus and the infrastructure bill, yields in the US practically double. I think they went from 0.8% on the 10-year level to 1.6% in the space of two months. So quite a significant shock in the interest-rate world.

South African yields followed. When they peaked out, we added onto the duration again, and then we had this bit of a risk-on type of environment where people said: “Well, look at the global economy, it’s starting to recover. We are emerging out of Covid and the recovery is in sight.” So there was that risk-on type of environment and you saw bond yields falling again in South Africa. Into that strength we basically started cutting duration again.

In September we had a bit of a bad month as far as risk assets were concerned and yields sold off, and we started building up our duration again. So it’s been the duration management.

RYK VAN NIEKERK: Arno, what do you mean by ‘duration management’?

ARNO LAWRENZ: I won’t get too technical on it, but duration is in a sense a risk measure for income or bond funds. Typically the way to understand this is a longer-term bond would have a longer duration. So it’s almost a term-to-maturity side of things. What they do really is they look at the present value of the underlying cash flows as a weighting of when you are actually receiving the cash flows or the interest payments on that bond. So it’s a measure of risk that we use. Essentially what it means is the higher the duration the more volatility you would expect to see within the fund. So when we say ‘we cut duration,’ we say we are reducing the risk within the fund.

RYK VAN NIEKERK: I rudely interrupted you there. What you were saying about credit risk?

ARNO LAWRENZ: I think an important point to be made here, as well, is that the other additional element in fixed income that sometimes is ignored and almost not taken into account is credit risk within a fund. This is where you move beyond government bonds and you start to get corporate bonds, bonds that are issued by banks. Where are you in their capital structure? Is it a secured bond, is it subordinated, and so on?

What you’ve seen in this world, this global context that we live in at the moment, global interest rates are at very low levels and so there’s this almost global search for yield. What you’ve seen as credit spreads – and that is the additional yield that corporate bonds offer over and above a government bond – have actually been reducing. So typically, if you think about it, over the last year the Sarb [South African Reserve Bank] cut interest rates in South Africa to essentially their lowest levels, certainly in my career. What fund managers in a way asked is: how can we compensate for this lack of income yield, or can we take on more credit risk? Because of the surge in demand, it’s really a price function, supply and demand. So what you see is that the credit spreads have reduced so the additional return you are getting by going down this risk spectrum has actually been reduced.

We’ve got to the stage where we are saying credit spreads in South Africa, and in the global context for many areas, are actually too low, and what we haven’t been doing is chasing after yield by going into the credit-risk spectrum. I think that’s sort of really the point I wanted to make on that one.

RYK VAN NIEKERK: South Africa has always been seen as one of the developing countries in the world that offers opportunities for international investors to invest in our bonds – which have much higher yields than first-world countries – and they make money through the interest-rate differential. It’s a so-called ‘carry trade’. What do you think is the future of the carry trade, especially in an environment where inflation is rising worldwide and we will see higher interest rates in due course?

ARNO LAWRENZ: I think there will be an element of that, certainly. It’s quite an interesting one if you look at our peer group in terms of emerging markets. So, on a valuation basis when we look at it Sasfin, one of the things that we can see very clearly is that by historical standards South Africa is unlike our peers. When I say ‘our peers’ I’m talking about the likes of Turkey, Mexico, Brazil and so forth – the emerging markets – and we are sitting at the very cheap end of valuations, whereas most of our peer groups are sitting on the expensive side of things.

So there is an element there which makes us much more attractive from a carry-trade perspective. I suppose the fly in the ointment, if I can term it that, for those investors is really the currency volatility. As you know, the rand has been fairly strong over the course of this year. I think there is an element of that but it’s more important, I would say, for the South African bond market to attract long-term flows rather than just a carry trade.

RYK VAN NIEKERK: The JSE recently stated that they will change the way in which they calculate capital flows, especially from the bond market. Initially we thought that since the beginning of the year R100 billion had left our shores – foreign investors withdrawing their investments here – but suddenly the new calculation indicates that there has actually been a net inflow of more than R20 billion. Now that is a significant difference. What do you make of this?

ARNO LAWRENZ: Yes. What has been a puzzle for a lot of people this year has been how strong the rand has been, and so perhaps data that the JSE has published maybe actually helps us to understand why the rand has been stronger than expected in the sense that I think it was almost R22 billion net that has been added by foreign investors. It could well be one of the causality dynamics behind the rand’s strength. I think it’s been a very useful addition to understanding the context of the currency, but the bond market as well. Although, having said that, I’ll still point out that the South African bond yields remain by global standards exceptionally cheap. We can still touch on why that’s the case.

RYK VAN NIEKERK: So let’s dive in there. Why is it the case?

ARNO LAWRENZ: As I mentioned earlier, around where our peer group is probably more on the expensive side relative to their own historical norms, South Africa’s idiosyncratic risk is the key here, that despite the fact that there have been some positives in the South African context. We can look at it in South Africa and say, yes, compared to a year ago, the economy is in a better place and so forth, but it still remains a very thin veneer in terms of fragility as far as the economic context is concerned.

So there are worries that South Africa is in a position where things can easily go wrong, and that risk of things going wrong needs to be priced into our bond market. Again, that’s a very direct message essentially to Treasury and to government around our fiscal sustainability.

We have got the Medium-Term Budget Policy Statement coming up in a couple of weeks’ time, and I think there will probably be better numbers than expected than three, four months ago. But that really comes down to the fact that you had this boost to government revenues, tax revenues, as a result of what was going on in the resource space, which shielded a lot of this fragility that we’ve seen. If you think when government came out with the budget at the beginning of the year in February and spoke about the public-sector wage bill, what the salary increases were going to be, immediately the public-sector unions went out and said – I won’t say ‘over my dead body’ – but it was more a case of ‘we are going to fight that’.

In the end I think government blinked in those negotiations, and the reason why they could blink and essentially accede to those demands, was precisely because they had had better tax revenues.

But the problem is that’s for this year and those increases are perpetual. So there could well still be some issues if we come down to it.

And then we start thinking about what’s going on in the world, and what’s going on in China and how closely connected we are to the slowdown that we’re seeing in China. If that is the case, we could have some issues going forward as well.

RYK VAN NIEKERK: Yes, there are many risks facing South Africa, especially fiscal risks. But my perception and my reading of graphs is that our yields are currently a lot better than they were when South Africa was still regarded as an investment-grade country. Is that the case and do you put that into perspective?

ARNO LAWRENZ: I would probably say that South Africa has been on a rollercoaster ride as far as our bond yields are concerned. If you look back in time, and let me go even further back and let’s go back to the global financial crisis of 2008, when there was a lot of concern about what it was going to do to the economies and so on – then we settled into a pattern. South African bond yields currently, by comparison to where we have been over the last number of years, are pretty much in a range. If I use the 10-year yield, for example, in South Africa for the last five years it’s been in a range mostly between 9% and 10% – a 1% range. We are on the higher end at the moment.

I’m going to exclude what happened in February/March last year when we had this massive spike in yields, but if you look over the last five-odd years, it’s gone nowhere. I think very, very briefly in 2018 we saw a dip in yields below 9% for the 10-year side of things. But, generally speaking, it’s been very, very stable – and this is the period over which we’ve been downgraded as far as our rating is concerned.

RYK VAN NIEKERK: Just lastly, what do you expect for fixed-income products over the next few years, because, as you said earlier, interest rates in South Africa are at I think a 50-year low, and a lot of people are living from fixed-income products. What do you think the prospects are?

ARNO LAWRENZ: Let’s exclude now all of the risks, the South African idiosyncratic risk, which says there could be a spike for whatever reason. Let’s take that out of the equation. Then we just say, what you get at the moment, if you invest in a 10-year government bond in South Africa, is a return which is in double digits; let’s call it 10%-odd. If inflation is – and we won’t go into that debate today, maybe we’ll do it at another time – 5%-odd on average, your real yield that you’re getting there is 5% over the course of the next 10-odd years.

Generally speaking, one of the first things that any financial advisor is going to tell a client is that you have to get returns in excess of inflation. That’s the first point. If you’re doing that, we don’t think South Africa is going to be in a disinflation environment, and that means you’re not going to be going backwards in real terms.

Certainly these are very, very attractive yields for income investors.

Of course, if you’re sitting in the short end of the curve, not the 10-year bond, but you’re looking at one-year returns in the money-market space, there your returns are sitting close to 4% which, as you said, are record-low type yields. So if you are surviving on income products, these income funds, you should be looking at funds which have the ability to tap into that long end of the curve, and you are able then to manage that volatility because you are then taking more volatility.

A lot of people who are reliant on these funds for their income don’t want to have the volatility. So how do you get that sweet spot?

Essentially what we try to do within our Sasfin Flexible Income Fund is to be a hybrid, saying we want to tap into the long end, those 10%-plus yields, but at the same time we are trying to deliver it in a way which is protecting the downside such that the volatility you experience is very much reduced. If you look at our performance, I think it bears testimony to the fact that we have been able to do that.

Certainly it is possible for income investors to get income yields that are well in excess of current inflation, and I think that’s an important space. It won’t last forever, so certainly it is there to be utilised at the moment.

RYK VAN NIEKERK: Arno, thank you so much for your time and for sharing your insights today.

ARNO LAWRENZ: Ryk, it’s a great pleasure.

RYK VAN NIEKERK: That was Arno Lawrenz, the chief investment officer at Sasfin.

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I predict that fixed income will outperform the stock market on an annualised basis over the next 2 to 3 years.

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