Rashaad Tayob of Abax Investments, Fund Manager of the Nedgroup Investments Flexible Income Fund provides an overview of the Fund’s performance for the last quarter and positioning going forward.
To watch a recording of this conversation, go to the Nedgroup Investments channel on Youtube. Alternatively you can listen to the coversation on these channels; Apple Podcast, Google Podcast or Spotify.
Moving into a post-pandemic would – things have calmed down a little but we are by no means out of the woods in terms of the pandemic or the subsequent economic effects.
The third quarter of this year saw a Fund return of around 2.1%. This is above the cash benchmark return of around 1.7% and above the peers of 1.4%, so it has been a stable quarter compared to the ups and downs of the previous quarters. The returns of the various asset classes in Q3 also reflect this:
- Currency: The rand appreciated slightly resulting in a return of about 2.2%;
- SA Bonds: Inflation-linked bonds returned about 1.2%; government bonds returned 1.4% which was above the cash return of 0.9% (STeFI call return).
- Cash: while this is a relatively low number, this type of return in cash is the new normal where rates have been reduced significantly. Our goal remains as it always has been, to try to generate returns above that a reasonably low level of risk.
- Property and Prefs: the asset classes that had negative performance in the third quarter were SA property and SA preference shares. SA Property continues to be under pressure as it is directly impacted by the post-pandemic economy.
Drivers of performance
The main driver of the return in the Fund was the SA Bond component. The Nedgroup Investments Flexible Income Fund has about 15% in nominal bonds and 15% in inflation-linked bonds. The stock selection within these bond categories helped drive performance over the quarter. Our holding on the nominal side in the R186 and R2030 bonds - and the I2025 in the inflation-linked bonds - were the sweet spots to be in and that’s where the Fund was positioned.
Offshore contributed 0.3% while SA Cash returned 0.2%. The small positions in SA Property and Preference Shares (2% in each) were still small detractors in the Fund due to the extent of the drawdowns in these categories even in Q3.
The COVID-19 Pandemic effect and South Africa’s debt problem
We are beginning to see the end of the depths of the pandemic and the levels of uncertainty are starting to decrease but it is not the end of the pandemic journey. Different sectors of the economy such as property and tourism remain under pressure. However, the biggest issue is that we are also left with the legacy of the pandemic which is a chronic debt problem.
Prior to 2019, South Africa had about R3.1 trillion in debt outstanding. In the beginning of 2007, before the financial crisis we had actually managed to reduce our burden - but from 2008 onwards during the Zuma years, this began to grow exponentially adding around R200bn to debt every year. Then, as the economy continued to struggle in 2018/19, we started to add R300- 400bn of debt in any given year. Now, to cope with eth effects of the pandemic we are set to add R820bn of debt in a single year. This will take South Africa close to R4trillion of debt.
We have added a lot onto the system this year. We have had a step-change in debt which will now continue to grow at around R300-400bn a year and at the same time revenues have fallen. The country is faced with a huge challenge to service this debt which will be highlighted in the medium-term budget.
To date, a lot of this debt has been financed by hot money flows – effectively portfolio flows into our bond market. We had about 40% of our bond market that was held by foreigners which has diminished significantly in the last year or two and has come down to around 30%. Portfolio flows were a big driver in how we were able to finance such a big increase in debt burden but unfortunately this wasn’t financed by foreign direct investment (FDI). This is a reflection on the unwillingness of foreigners – and locals for the matter - to finance the type of projects that you need to stimulate the growth of the economy given all the political and economic uncertainty.
The rand has been on a roller-coaster even more so than usual. From the beginning of the year we depreciated around 37% in one of the sharpest moves we have ever seen, although it has recovered somewhat since. However, the rand started the year on a very strong note. If you look back to 2019 at more normalised levels the currency is actually only about 14% weaker, which on an annualised basis is only about 7.6%. Looking at the rand’s performance relative to emerging markets, we have only underperformed by about 5% at the moment. Our view is that at these levels it’s time to start added some foreign currency exposure.
Will the SARB move to close the gap between repo rate and the SA10Year Bond rate?
We are at extremely low levels on the repo rate and we’ve had very aggressive SARB cuts. There is still the potential that we will see some easing going forward but there is a big gap between where the repo rate is and where the government needs to fund itself. The government has had to up the weekly auctions from around R3billion a week to around R8 billion a week, which is why bonds continue to stay under pressure even though the yields on the front end is extremely low.
The South African Reserve Bank (SARB) has started doing some Quantitative Easing (QE) but not to the extent that some global central banks have been. The question is how long it will be before they are forced to embark on significant QE because the gap between the front-end rates and long bonds is untenable and they do need to provide some support to the fiscal. It seems the SARB are looking to see some credibility from the Treasury before they provide that line of QE. We continue to watch this space.
Inflation-linked bonds remain attractive
We talked previously about inflation-linked bonds as an attractive class. We had around 5% in Q1 and we have increased this significantly to around 15%. Yields have come down from the 4% level to around 3% but we do still feel that on a risk-return basis inflation linked bonds are attractive. The weighted average return is around 2.5 years so we have focussed on the short dated bonds.
This Fund’s strategy has always been diversified alpha. We wanted to buy a broad range of fixed income assets and strategies to get a cash plus return with a low level of downside risk. Nothing has changed with this pandemic, but the importance of diversification has certainly been highlighted. Diversification was always critical but now it is even more so.
This is playing out in the portfolio with the mix between floating rate bonds (33.3%); fixed-rate bonds (14.5%); SA inflation-linked bonds (14.5%); convertible bonds (2.3%); SA preference shares (2.2%); a small exposure to SA Property (2.1%) and offshore property (0.1%); offshore bonds (10.8%) and SA Money Market (12.5%).
We’ve taken advantage of convertible opportunities as they arose. The estimated return of 6.1% has fallen slightly as a function of how the front-end yields have fallen. Meanwhile, fund duration is at 1.37%.
SOEs in the portfolio: What is the rationale?
There has been very little control over SOE spending across the board due to varying levels of mismanagement. Our bigger positions are in Land Bank and Eskom. On the Land Bank side, the majority of our holding is just under a year. We did this on the basis that Land Bank had just been through a reform process. They are also relatively small – there book is around R40bn. They have had several capital injections over the last few years so in terms of being able to support the critical agriculture industry in SA, it hasn’t been a big drag on the state. We viewed it as a critical SOE which has received a consistent level of government support. Our term to maturity is just over a year and we think that’s enough time to get an attractive return with low risk. We will assess it when it matures
We have Eskom guaranteed debt which we think is great. We also have 2% position in unguaranteed debt but that comes to maturity in January next year and we think, given the capital injection of R60bn per year, this is quite safe and will produce a great yield. We are happy that the yields on these shorter-term, relatively low risk positions are secure.
We continue to look out for opportunities as we move into Q4 2020.