Still value in local fixed income

For fiduciaries, the ongoing search for yield may be closer to home than you might think, says Melville du Plessis, portfolio manager at Sanlam Investment Management

Investment decisions are frequently made in the face of uncertainty – at times more so than others. The global investment landscape is characterised by constant flux due to policy decisions, economic trends, geopolitical risks, and heightened complexity. Locally too, fiduciaries and other allocators of capital have had to digest a series of rather unpalatable political events. This year alone we’ve seen the surprise Cabinet reshuffle, the so-called continued ‘state capture’ debacle and the release of a Mining Charter draft so punitive and unreasonable that it’s highly unlikely to ever be implemented in its current format.

Add to that the economy’s entry into a so-called ‘technical’ recession, an unemployment rate of close to 28%, more downgrades looming, and little on the horizon to signal an economic lift-off and an improvement in the fiscal budget anytime soon. It is not surprising that SA investors have a gloomy outlook when considering investing in local assets. Cash is currently giving you just under 6% and historically has given returns between 5% and 12%. SA equity has offered investors a wide range of returns between a staggering –38% and 70%.

Interestingly, the poor sentiment towards domestic assets stands in contrast to foreign sentiment: despite all the uncertainty facing South Africa, foreign investors are grabbing the yields on offer from SA fixed income assets. According to the Institute of International Finance, foreign inflows into emerging debt markets have exceeded $100 billion in the first half of 2017 and according to Deutsche Bank have now reached an all-time high at the beginning of August – totalling $700 billion. SA received its fair share – inflows totalled R30 billion in the second quarter of 2017 and almost R45 billion year to date.

What do foreigners see that local investors don’t? Confirms Du Plessis, despite the uncertainty in South Africa – or perhaps because of it – we see value in local fixed interest and credit markets.

The search for yield offshore

For many disgruntled South African investors, the desperate search for yield may have driven them offshore. But whether there is better value on foreign shores compared to back home in South Africa requires closer scrutiny.

The risks associated with exposure to low-yielding offshore debt are significant, as investors are faced with the ‘double whammy’ of both lower yields as well as, paradoxically, decreasing availability of quality assets. Nearly a decade of quantitative easing and loose monetary policies have sent global bond yields to all-time lows (and developed market bond prices sky high.) Global bonds are simply not looking attractive. Take the example of the German 10-year bund which is trading at 0.42%, or the 30 year Japanese bond yield at 0.85%.

Has loose monetary policy created inflated asset prices elsewhere in the financial system?

The world’s largest central bank, the US Fed, currently has more than $4.5 trillion on its balance sheet, made up primarily of bonds that it purchased in response to the Global Financial Crisis. Their quantitative easing programme was originally designed to inject money into the economy and encourage risk-taking. But the potential for a number of unintended consequences from this massive expansion of Central Bank balance sheets and the US Fed’s zero interest rate policy exists.  This includes the inflated price of US government bonds and other financial assets as well. The Fed’s balance sheet is now big enough to buy ten of the largest companies on the S&P 500, including Amazon, Apple and Exxon Mobil.

Interest rates are now at their lowest levels ever and the concern is that these low interest rate policies may also have spilled over into other asset classes, leading to overinflated asset prices elsewhere.  Significantly undervalued assets offshore seem to have become a scarce commodity.

Negative-yielding debt is on the increase

It’s not only the absolute size of these debt numbers but also the rise in negative-yielding debt that is remarkable. Says Du Plessis, ‘We have reached a point in history where some debt instruments even carry negative interest rates. You actually have to pay someone to lend them money! During the last few years the amount of negative yielding debt increased significantly, with the total amount peaking at around $13 trillion during the second half of 2016. It is a staggering amount.’

It is clear that the debt dynamics in the world are not on a sustainable path, but how will central banks shrink their balance sheets and what will the consequences be?

How to shrink the world’s largest balance sheets

The Fed has already started raising interest rates, but it has not yet started the second part of the journey: unloading its balance sheet. The Fed has two choices: It can simply allow the bonds to run off naturally when they mature, or it can actively sell them back into the market before maturity. If the Fed gets its tapering process wrong, possible consequences include a decline in equity other asset prices.

It is clear that the level of uncertainty in the world has increased and there are fewer straight-forward capital allocation decisions in today’s markets. And, says Du Plessis, while everyone may be in a hurry to send money offshore, don’t forget to take advantage of the opportunities back home as well. For investors looking to achieve a sustainable, diversified yield, it might be closer to home than you think.

In comparison, SA bonds look attractive

The good news is that unlike the US and the rest of the developed world, South Africa hasn’t seen yields moving lower. In spite of the economic and political uncertainty, South Africa still offers good investment opportunities available in the form of local quality credit counters which offer an attractive margin of safety. Investors are actually being compensated with a healthy premium for the level of risk taken, currently around an 8.5% to 9% nominal yield for SA 10-year bonds plus an extra 1% to 2% for credit. The yields on fixed interest and credit assets which we currently see in South Africa are actually quite rare in the global context.

In fact, SA long bonds are still offering among the highest local currency real yields in emerging markets. ‘Even if inflation settles at the top end of the 3% to 6% inflation target, a real return of 3% is still on offer from vanilla government bonds, and that’s before one starts investing across high quality companies and credits where you also get an additional 1% to 2%,’ says Du Plessis. This is particularly attractive given the low real returns available in global bond and equity markets.

In addition, SA inflation is currently trending downwards, while inflation in developed market countries is picking up. South Africans could therefore see more rate cuts over the next year, which would be a boost to SA bond prices.

What happens to SA bonds if they’re downgraded further?

If – or when – SA debt will be downgraded further should not be the main focus point when formulating investment decisions. At the moment, South African assets – when compared using measures such as credit default swap spreads – are already similar to non-investment grade countries. In addition, a large and sustained drop in asset prices is not necessarily expected, but is dependent on the global backdrop, together with specific local factors at play should further downgrades transpire. The SA government should theoretically always be able to service its own currency debt (as it’s in control of the money printing press). But there are risks. The mismanagement of an economy can manifest itself in rising inflation, which could halt the decreasing interest rate cycle that the Reserve Bank signalled recently with its first interest rate cut in five years during July this year.

The sleep-easy option

Fixed income performs an important role in helping investors preserve capital and generate a more stable level of income. In this category, Du Plessis manages the Sanlam Investment Management (SIM) Active Income Fund, which aims to add outperformance to its cash plus 1% benchmark by tactical asset allocation between fixed income yielding asset classes across the entire duration and credit spectrum. Although the category allows for offshore investment, the SIM Active Income Mandates focus only on local asset classes and as such don’t hold any offshore assets. We believe this makes it a valuable local building block for institutional investors. They can manage their foreign allocations as they see fit while having a local only building block which does not take up their foreign allowance capacity. It also allows investors to sleep easier – knowing they have no exposure to the risks looming over global bonds at the moment.

Du Plessis concludes, ‘We believe SA fixed-income assets are still attractive within the global context of a low-yielding environment. Locally, we see real yields of between 2% and 3% on offer against a backdrop of declining inflation.’