Douglas Nicol, Investment Analyst at Nedgroup Investments, discusses interest rate developments over the last few months and the impact on interest earnings for cash and income generating investments. He also poses a credible alternative for investors in interest bearing funds.
South Africa now faces one of the steepest yield curves in its democratic history, resulting in falling returns for short-dated bonds, while longer-dated bonds remain stubbornly high. Over the past few years, we’ve seen a large movement of assets into short-dated interest-bearing funds whose return prospects have been reduced by cuts to central bank interest rates.
A shifting yield curve
In January, the yield on a 1-year bond (R208) was 6.72%, falling to 4.85% after the crash. Longer-dated bonds, such as the 5-year (R186) and 10-year (R2030) increased from 8.26% to 11.05% (R186) and 9.04% to 12.34% (R2030) following the sell-out of SA bonds. What started out as a fairly flat yield curve across all bond categories, changed dramatically in March. As yields for medium dated bonds rose, a lot of fund managers allocating to these two bonds in Q1. By the end of Q2, we’d seen the short end come down even further mainly due to the SARB’s aggressive rate cuts. Some of the medium-term bonds (R186 and R2030) have also come down, but the long end of curve has failed to adjust and has increased. As a result, investors are now confronted by one of the steepest yields curve since 1994.
SARB forecasts: inflation pressure easing
The SARB focuses on three main variables, namely headline inflation, GDP growth rate and the output gap. When the output gap is positive (i.e. the economy outpaces growth or its potential growth rate), we’re likely to see inflationary pressure. Over the last six months, the SARB’s expectations for inflation and the GDP growth rate have come down. As economic growth has stalled over the previous number of quarters and there is an expectation for further GDP contraction, so the output gap has widened, which has enabled an environment for the introduction of a monetary easing policy. By mapping the forecasts, we expect the Repo rate to stay below 4% for the next two years, rising to about 4.7% in 2022. If we look at where inflation rates are expected to go, 4.3% in 2021 and 2022, we’re start to see an environment where real interest rates are close to zero and possibly negative at time.
Impact on real rates
Cash has been a really good asset allocation in recent years offering relatively high real returns in very short-dated instruments and providing high levels of capital protection. But that has changed. The Jibar rate (a proxy for cash returns) has come down as a direct result of interest rate cuts. Although the inflation rate is low at the moment, there are still incredible pressures on that going up and we’re likely to see that rise over the next few months. As a result, we’re likely to see the real return on cash going close to 0 and potentially negative.
Short-term interest rates are really important to SA retail investors. About 42% of retail net assets are invested in interest bearing funds, more than the combined amounts invested in SA multi assets. The multi asset (MA) income and interest bearing (IB) money markets’ share of the market has almost doubled over the last five years. This is important because both the IB short term and IB money market are exposed to very high quality, but very short-dated, assets. While these funds offer significant downside protection, liquidity and often yield enhancements above that of bank deposits, they are very vulnerable in a rate cutting cycle and inflation spikes.
The MA income funds offer slightly better flexibility in that they are invested in asset classes that provide greater yield enhancements, such as convertible bonds, preference shares and inflation-linked bonds and can offer offshore exposure. They also have a capital preservation objective over quite short periods of between 3-6-months. As a result, they are limited to the amount of risk they can take and tend to sit quite low down on the yield curve.
Where can investors find yield?
In March, the difference between a 5-year bond and a 3-month bond spiked to levels we haven’t seen since 1998. That has since come down as market sentiment received during Q2. The middle end or medium-term spread between the 10 and 5-year bonds also spiked in March, but hasn’t come down and neither has the spread between the 20 and 10-year bonds. These two sections of the yield curve have both steepened and are now at some of the highest levels we’ve seen since 1994.
Across the board, emerging markets have cut interest rates and even more this month. We have also observed a reduction in yields for longer-dated bonds, except for South Africa where we’ve seen an increase. This could be because at the longer end of the curve there is significantly more risk and investors are concerned about a potential default in South African debt and the prospect of higher inflation environment in the future, as the budget deficit weighs on the Rand.
A multi asset low equity strategy as an alternative to cash
To remain invested in IB funds, investors will have to accept lower level of returns. One alternative is to increase bond exposure where investors are likely to outperform the short end of the curve and receive quite high returns compared to inflation. There is also a level of capital preservation if they stay in the medium end of the curve. Bonds are, however, exposed to interest rate sensitivities and with fixed returns, are vulnerable to inflation and default risk.
We think that moving into a multi asset low equity strategy as alternative to interest bearing strategy is good idea for investors looking to move from cash in the search for higher yields. It provides investors with greater exposure to growth assets, such as equities, commodities and offshore assets, which offers Rand protection and allows the manager to play across longer-dated bonds. Managers are constrained in terms of the amount of risky assets they can take on and equity exposure is generally capped at 40%. However, investors should expect periods of drawdowns and underperformance versus IB funds over a 12-month period.
Over the past, Multi Asset Low Equity funds have shown to deliver greater than 50% probability of outperforming an inflation plus 3% benchmark, the average return of the Interest-Bearing short-term fund category and the Multi Asset income fund category over 1, 3, 5 and 7-year periods. The longer you are invested, the greater the probability of outperformance. There is, however, more volatility over the 1-year period given the asset composition and exposure to growth assets
Historical data indicates that the multi asset low equity model portfolio underperforms during interest hiking cycles and tends to outperform in periods after rate cutting cycles. This makes economic sense to us, as buying into growth assets at the bottom of a cycle tends to position a portfolio to enjoy the recovery period.
There’s currently a lot of risk facing cash investors who, over the last few years, have enjoyed incredible real returns. While these investors can remain invested in cash and accept lower returns but good capital protection, some may be forced to seek higher returns. We believe that moving into a more diversified portfolio, like a low equity fund, is a more credible alternative. Investors gain access to a controlled level of growth, managers remain focused on capital preservation over longer periods with these funds likely to generate inflation plus returns.