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SA government bond yields may be down, but they’re still hugely attractive

Marriott Asset Managers sees the five-year bond as a very low-risk investment that gives substantially better returns than money sitting in a bank account: CIO Duggan Matthews.

RYK VAN NIEKERK: Welcome to this Market Commentator podcast – my weekly podcast where I pick the brains of the leading investment professionals in South Africa. My name is Ryk van Niekerk and my guest today is Duggan Matthews. He’s the chief investment officer at Marriott Investment Managers.

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Marriott interestingly was established in 1862 and is one of the oldest financial services businesses in the country. The group has around R35 billion under management. Old Mutual acquired Marriott in 2005.

Duggan, thank you so much for joining me. First of all, you are based just outside Durban in Hillcrest, a wonderful and beautiful part of the country. I don’t think there are many chief investment managers outside Joburg and Cape Town, but I guess technology has removed the borders.

DUGGAN MATTHEWS: Yes, Ryk. That’s 100% accurate. I think we are one of the few. There are a couple of asset managers also located in Durban, or in the Durban area, but we’re in the minority. Having said that, it’s a great place to work in. As you say, technology allows for flexible working arrangements, so people are working from strange places these days, I suppose.

RYK VAN NIEKERK: But let’s talk about investments. Marriott is part of Old Mutual, as I’ve said, and is an established asset manager, but you are seen as a boutique within Old Mutual. You describe your investment style as being income-focused. Just exactly what does that mean, and how does it differ from other investment managers who focus on fixed income?

DUGGAN MATTHEWS: Sure, Ryk. It’s a great place to start, I think. That income focus of ours really defines the business and differentiates us from the competition. I think we’re pretty unique in that we do focus on income, and that’s not saying we don’t concern ourselves about total return and capital outcomes. We absolutely do. But we recognise that the ultimate driver of good returns comes from income, and income growth from investments.

A big reason for our focus on income is that we recognise that so many investors are investing to draw an income stream from their savings because they’re entering a post-retirement phase.

We think it just makes good sense to invest in businesses that can produce a steady income stream, so that it can allow those businesses to draw that income from their portfolios without eroding capital – which means selling the bonds and the shares that actually produce the income, the capital base. And that’s a good way of making sure that your annuity will last you for the length of your retirement. At the end of the day, retirement is a long story, 20 or 30 years, so you want to keep that capital base intact for as long as you can.

Marriott’s flagship funds

RYK VAN NIEKERK: Yes, absolutely. We receive many questions on a daily basis from our readers, from our radio audiences, and the majority are from pensioners who are concerned about fixed income. We are living in a world where the interest rates are at all-time lows, including in South Africa. But when I look at your High Income Fund of Funds, which is one of your flagship funds, the return over the past one year [was] 10% total return, the income portion 7.1%. I think a 10% return over the past year is actually phenomenal and beats your own performance over all the other periods listed in your fund fact sheet. That includes two years, three years, four years, five years and since inception. How do you approach it? What do you invest in?

DUGGAN MATTHEWS: It was a great year for investors in our High Income Fund, as well as the sister fund, which is our Core Income Fund, both being our flagship funds at Marriott. The reason for, I suppose, a really good year – which we are obviously pleased to have produced for our investors – is that Covid and the economic volatility around the Covid crisis, as crises tend to do, presented a really good opportunity for the fund. That was a huge sell-off in government bonds which occurred in March and April last year.

The result was the yields on medium-term government bonds – the R186, for instance, which is a bond maturing in 2026 – touched 12%.

Obviously, when you consider that cash in the bank now is yielding 3.5%, you can comprehend the kind of magnitude of that opportunity. We were well positioned to take advantage of that opportunity, and we did. Yields have obviously come down a lot since then, which has translated into capital gains for investors. The end result has been a really pleasing year for our investors in those portfolios, in our income funds.

RYK VAN NIEKERK: What is the risk profile of this fund?

DUGGAN MATTHEWS: The fund is aimed at, I think, a moderately conservative investor, an investor looking to draw a relatively high level of income from their savings; [it] is someone who can’t take on too much volatility, so is concerned about capital losses over a 24-month period. So ideally the investor should have a two-year time horizon. We believe the Core High Income Fund is a very good solution for that type of investor. The current yield on the portfolio is close to 6% and, if you consider cash in the bank as yielding 3.5%, we just think it’s a useful proposition in the current climate.

RYK VAN NIEKERK: I recently spoke to Patrice Rousseau from Ashburton pretty much about the same topic we are talking about today. He said investors may look at an option to move from fixed-income to low-equity multi-asset funds, and he doesn’t see this trend. Are you seeing a trend of investors moving from fixed-income to the multi-asset space?

DUGGAN MATTHEWS: I think what we’ve seen in recent years, because of the disappointing returns from equity markets, is a shift perhaps out of balanced portfolios with more equity exposure into more fixed-interest-type portfolios, because the returns from cash and bonds have been significantly better. So that’s the trend we’ve seen in recent years.

Budget 2021 expectations

RYK VAN NIEKERK: We will see a budget announcement this week and we expect very, very bad news. I think the surprise will be if the bad news is not as bad as many people expect. How do you think that will affect markets, especially the income markets?

DUGGAN MATTHEWS: It’s going to be an important announcement for the bond markets. I think you make a good point there. There’s so much bad news priced into South African government bonds that even though it could potentially be not a very positive budget, a budget clearly showing some financial stress on the part of the SA government, I think most of that bad news has been priced in. And you might find that because the South African economy has been a little bit more resilient – we’ve had a rebound in commodity prices – that the expectation the markets have will be potentially overly pessimistic.

Our expectation is that the budget is probably going to exceed those expectations, which is likely to be reasonably positive for South African government bonds.

I think the reality is, if you look at the pricing of bonds, so much bad news is in that price. As a result of that, we’ve got a situation where our bonds are offering among the highest real yields in the world, and one of the steepest yield curves as well in the world. So I think there’s more upside potential going forward than downside potential, for sure.

Bond ratings and yields

RYK VAN NIEKERK: As you’ve said earlier, we’ve seen a significant strengthening of bond rates from the R186 being at over 12% and currently around 7%. The 10-year bond has also strengthened significantly. And that is post a downgrade to junk status by Moody’s and the other agencies. We will probably see more downgrades this year, which will not be a surprise due to the weakening fiscal position of the state. Are you concerned about rating agencies and the ratings of our bonds?

DUGGAN MATTHEWS: No. I think, once again, it’s in the price. If you think about the yield backdrop globally, 25% of global bonds are yielding negative interest rates. So if you put your money in bonds, you’re going to get a negative return if you hold them to maturity. That doesn’t even take into account inflation. The yield of the US inflation-linked bond at the moment is sitting at -1%. In the UK for a UK 10-year inflation-linked bond it’s sitting in -2.8%.

So although our yields have come down, they still remain hugely attractive relative to what is available in the rest of the world. I’ve mentioned that they are among the highest in the world. They do come with additional risk. Of course they do. But I think if an asset manager can manage that risk sensibly, investors looking for income are going to struggle to find a better place.

And from our perspective, to manage that risk of a potential government default, we would stick to government bonds with maturities less than 10 year, because although we do think we’re not on a great path from a fiscal sustainability perspective, we still think it’s going to take a lot of time before we eventually end up at that point.

RYK VAN NIEKERK: The word “default” just sent a shiver down my spine. But you also said managers should manage their portfolios “sensibly”, which is an interesting term for an asset manager. What do you mean by that?

DUGGAN MATTHEWS: I just think you’ve got to be cognisant of the risks. You don’t want to end up in a situation where you are reaching for yield. So you want to try and achieve a good yield, but you want to make sure the risk of disappointments and capital volatility is minimised. And when you consider that South Africa is on a difficult path from a debt-sustainability perspective, for us that negates very long-term government bonds from our investible universe. We’re not interested in lending to the government for periods of 10 years or longer.

Our preferred government bonds have a maturity profile of just over five years, because we think within that framework, that time frame, you’re going to pick up a really attractive yield, and the potential of any defaults within that time frame is very, very remote.

So that is how I think you can go about sensibly using the government bond market to achieve good outcomes for investors.

Fixed-investment product strategies

RYK VAN NIEKERK: Duggan, we are living in a very interesting interest-rate environment – not only locally but also internationally – where rates are at all-time/record lows. Now, many people who live on fixed-investment products really battle. Let’s use an example of a 60-year-old pensioner who has R1 million available to invest. The person is, however, very concerned about capital preservation, but would like to see a higher yield. What would your advice be for such an individual?

DUGGAN MATTHEWS: Of course it always relates to the risk appetite of the investor, and how much volatility they can stomach. But I think the reality is that, if you’re not going to take on any duration risk, or market risk whatsoever, and you’re going to just end up in funds very close to money-market vehicles or cash-type funds, the return outlook for those types of portfolios is not good at all. I mean, you’re going to be lucky if you get 4%.

So I think those investors are going to have to consider maybe taking on a little bit more risk from a volatility perspective. But, having said that, that doesn’t mean you have to look at high-risk investments. We still think a five-year government bond is a very low-risk investment in the context of South Africa. And there you can get substantially better returns than you can with money sitting in a bank account.

And remember, one also needs to understand that government bonds are safer than bank deposits because at the end of the day governments bail out banks and not the other way around.

So I think there is an opportunity for retired investors who need to draw a relatively high level of income to maybe start thinking about not having all their money in cash, but looking to include some shorter- to medium-dated government bonds in their portfolios so that they can get a higher yield, and draw more income from their savings safely. Essentially that’s what our Core Income Fund and High Income Fund are all about.

RYK VAN NIEKERK: What do you think is a realistic expectation for additional yield if you move from cash to an income fund?

DUGGAN MATTHEWS: That’s a really good question, Ryk. I think if you’re looking at 4% returns in your cash-type investments, if you are prepared to invest in instruments with a bit [of a] longer term, such as those bonds that we’ve been chatting about, you can push that return up to about 6% or 7%, as well as a yield of about 6%. You’ll have a bit more volatility, but if you’re there for two years and you have that type of time horizon, the probability of achieving a 6% to 7% return and a 6% level of income is very, very high in our opinion.

RYK VAN NIEKERK: The volatility is interesting, especially in an income fund. Would that be volatility in capital values, or in actual returns?

DUGGAN MATTHEWS: It will be short-term volatility in capital values, but very, very low in comparison to the type of volatility that you would see in equity portfolios or balanced portfolios. Minimal volatility, but volatility nevertheless, because if you contrast that to money-market funds, there’s obviously zero volatility in those types of portfolios. But the trade-off is very, very low returns.

So we think at this point in time it makes sense to maybe take on a little bit of volatility, invest outside of pure cash deposits, look at those high yields on offer by government bonds, be sensible by restricting the term that you go out to, to around the five-year mark – and you can achieve a good outcome, despite the very low cash rates in South Africa.

Listed property

RYK VAN NIEKERK: Just lastly, I am looking at your current asset allocation of the High Income Fund of Funds. As you said earlier, around 50% of the portfolio is in government bonds. But I also see that you only have 0.6% invested in real estate investment trusts. In the past listed property was a great asset class. It has performed poorly in recent years owing to the poor performance of our economy. Are you looking at the property sector? Do you think there is value and potential yield on offer?

DUGGAN MATTHEWS: We probably see a bit of value there, but that sector is under so much pressure, and there’s so much uncertainty with regard to the outlook of that sector. We are seeing negative rental reversions and there’s an oversupply of space. So that’s why you’ve seen that 50% allocation in bonds. What we want to do is we’re going to take that yield, we want to hold that instrument to maturity, and we want to come down the yield curve which results in capital appreciation. At the end of the day you can achieve a lot more predictability using bonds in an income portfolio, as opposed to listed property. And hence our preference for [bonds].

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

DUGGAN MATTHEWS: Pleasure, Ryk. Thanks for having us.

RYK VAN NIEKERK: Duggan Matthews is the chief investment officer at Marriott Investment Managers.

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