One of the key local investment themes over the past five years has been the outperformance of domestic bonds. While the FTSE/JSE All Share Index returned just 6.4% per annum between the start of 2016 and the end of 2020, domestic bonds returned 10.4% per annum over the same period.
A key question facing asset allocators is whether this trend is likely to continue, or whether leadership might shift back to the equity market.
Arno Lawrenz, CIO at Sasfin Asset Managers and manager of the Sasfin BCI Flexible Income fund, said answering that question requires understanding the global context.
“It is about the flow of funds,” said Lawrenz. “We are a small, open economy, very much dependent on capital flows from foreigners.”
The fortunes of the local bond market therefore depend significantly on international investment considerations.
“The first thing to think about is the stretched valuations in equity markets, particularly in the US,” Lawrenz said. “Those valuations are a concern, although there are some mitigating factors. There will be an earnings recovery in 2021 and into 2022, and that will support the backdrop.
“However, our expectation it that because of these high valuations, you are more likely to see a bit of a derating in valuations rather than simple one-to-one correlation between an earnings recovery and share prices.”
Central banks are also maintaining interest rates at very low levels, and most developed market bonds are offering negative real yields. This means that developed market bonds are likely to remain unattractive.
With a reflationary environment anticipated in the world’s major economies, history would suggest that the dollar will also be under pressure.
Hunt for yield
The likely outcome in this scenario is that risk assets are likely to continue to outperform. There will also be an ongoing search for yield.
Spreads on credit in developed markets are, however, largely unappealing.
“Global credit spreads are, in my mind, fully discounting a normalised economic situation,” Lawrenz said. “If you use the US as an example, which is probably the country most tangibly hit by the virus: they are experiencing record numbers of deaths and infections, yet credit spreads are at their low points, essentially discounting a fantastic economic opportunity.
“That is forcing global investors down the risk curve. This speaks to a wave of money that will search for yield, and South Africa could be an important destination for those sorts of flows.”
There is therefore still an attractive opportunity in local fixed income, but Lawrenz noted that it is critical to manage the idiosyncratic risks in South Africa.
He noted that the current yield on the Sasfin BCI Flexible Income fund is 8.2%, which is noticeably lower than the 9.4% yield on the FTSE/JSE All Bond Index (Albi). A key reason for this is that the portfolio has been positioning away from fixed-rate bonds in favour of floating rate bonds, which typically have a duration of three months. These constitute close to half of the fund at the moment.
As the table below shows, the fund’s exposure to fixed-rate bonds is significantly lower than it was 18 months or a year ago.
Sasfin BCI Flexible Income fund
This also means the duration of the fund has come down materially. As the graph below shows, it ended 2020 at a low point relative to the Albi.
Sasfin BCI Flexible Income fund
He does not expect the duration in the fund to remain this low through the year, but managing it in a way to manage risk is a key part of the portfolio’s strategy.
“The active duration management of this fund over the course of this year, in my mind, will be the key differentiator going forward on the performance side,” Lawrenz said.
The Sasfin BCI Flexible Income fund has been the top-performing South Africa multi-asset income fund over the last three and five years.
To the end of December, it delivered a three-year annualised return of 10%, against a category average of 7.2%. Over five years, it returned 11.4% per annum, against a category average of 7.6%.
Over this full period, the fund was managed by Philip Bradford, who left Sasfin at the end of 2020 to join PortfolioMetrix.
Patrick Cairns is South Africa Editor at Citywire, which provides insight and information for professional investors globally.
This article was first published on Citywire South Africa here, and republished with permission.