SIM Enhanced Yield – Client Update

March 2020

To say that this has been quite a month would be the understatement of the decade, or rather the century. No one needs reminding of the unprecedented and historic times we currently find ourselves in. Not least because clients are likely to be reading this while confined to self-isolation at home and under a national lockdown. We find ourselves living through a historic moment in time on a personal level, but also very much so from a financial market and real economy perspective.

The economic shutdowns observed throughout the world will likely lead to one of the worst global economic contractions observed in our lifetime. The estimates of the impact on global economic growth are changing constantly, but the contractions we’ll witness this year would not have been seen for the last 100 years or so. One would have to go back to look at periods such as the Great Depression in the 1920s or WW1/WW2 to see contractions of a similar magnitude.

The SA economy was already in a precariously weak position, having seen stagnant growth for quite some time, and the fiscal outlook had deteriorated for the last number of years – something which we have talked about and written about extensively. The events that unfolded over the last few weeks quickly brought to the fore issues that were going unaddressed for some time. The economic outlook has deteriorated rapidly and one could easily expect a real GDP contraction of -5% (or most likely worse) in South Africa for 2020.

Financial markets were not left unscathed. Pretty much every asset class in the world ended the first quarter of 2020 in sharply negative territory. Only ‘safe haven’ asset classes such as gold and US cash were spared, but even these traded at elevated levels of volatility which was quite remarkable and highlighted the extent of financial market stress felt. With the ‘tide going out’ and South Africa’s weak fundamental position exposed, our financial asset prices took a beating. The currency weakened and touched above 18 to the US dollar towards the end of March (albeit also due to dollar strength). Local REITs and equities suffered significant drawdowns. And our local bonds felt the brunt of a sell-off which we have not seen since December 2015, or in fact in the last few decades.

The current environment is exceptionally ‘fluid’ with events unfolding at a dramatic pace. One can (and we all should) spend quite some time recapping all the exceptional events over the past few weeks and months, as well as the resulting implications for real economic activity, financial markets and of course society as a whole. The following is relevant to the fixed income markets: during March we witnessed the US Fed cut the policy rate by 100bps to effectively zero; the SA Reserve Bank (SARB) also cut the policy rate by 100bps; all of this not being enough to support local bond yields with yields continuing to trade at unpresented levels of volatility; the SARB subsequently stepped in to purchase government debt onto its balance sheet – whether this is labelled quantitative easing or credit rationing, it is a remarkable policy move either way.

The SIM Enhanced Yield Fund held up very well for the month, all things considered. We believe the Fund did well during the period for at least two main reasons: performance and positioning.

Performance

Firstly, from a performance point of view, we believe the Fund held up remarkably well during the very tumultuous period, even though the Fund still posted one of its worst months since inception almost nine years ago. This is a tough pill for us to swallow given that we place a strong emphasis on capital preservation while delivering outperformance. The Fund has now had a total of seven negative months out of a total of 106 months – more than 90% positive calendar months. However, one needs to recall that the Fund is positioned to clients who have at least a 6- to 12-month investment horizon. The current entry point and prevailing yields available suggest very appealing forward-looking returns. The negative drawdown also comes at the tail end of the longest run of positive monthly returns the Fund has ever had, as we have managed to avoid any negative calendar months since December 2015, making it more than four years of consecutive positive months – a period which was also associated with elevated levels of volatility and uncertainty in local fixed interest assets. The Fund has posted exceptionally good performance over the last three to five years in particular.

To put the performance into context, the following graph shows the performance of the SIM Enhanced Yield Fund compared to the ALBI – but only for the months where either the ALBI or the Fund posted a negative return. The ALBI returned -9.7% for the month, making it one of the worst months on record for nominal bonds. There was also little benefit from holding inflation-linked bonds (ILBs), which closed down 7.1%. As can be seen from the following, the Fund managed to avoid any negative calendar months for the last number of iterations during the past four years when nominal bonds posted a loss, with the last month now being pulled down by nominal bonds as well as ILBs pulling back sharply:

*Estimated returns for March 2020

It also bears remembering that historically a negative calendar month for the Fund was subsequently followed by a very strong positive month or months:

This is due to various factors, including the mean reverting nature of yields and our active management style and philosophy. Generally, the negative calendar months are caused by a (sharp) sell-off or weakness in bond markets. This subsequently means that yields are more elevated and thus improves the forward-looking return prospects of the Fund. In fact, when looking at the rolling 12-month performance one can see that historically the Fund delivered the best performance subsequent to a period of underperformance:

All of this suggests to us that not only has the SIM Enhanced Yield Fund held up and performed remarkably well during the recent period of extreme and acute market stress in SA fixed interest assets, but in addition the forward-looking return prospects of the Fund look particularly appealing.

Positioning

Secondly, the Fund held up well from a positioning point of view. We were positioned light on market risk and duration, as well as credit risk, coming into the year and with the onset of the market sell-offs. We could have easily justified much higher market risk exposures given the very elevated level of yields while at the same time inflation had been trending lower with inflation expectations and risks also tilted towards the downside. As such, our positioning was much more conservative than it could otherwise have been, to a large extent insulating the Fund from the sharp sell-offs. We managed to quite successfully allocate capital during March, being able to take advantage of higher yields in sharp sell-offs and taking profit from any reversals. We increased market risk during the month, but still to a limited extent, given the very heightened levels of uncertainty and the fact that this could prove to be quite a drawn-out period of economic weakness and market stress.

From a credit point of view, it is fair to assume sector-wide weakness with very few companies or issuers left unaffected if the current situation persists. Credit is illiquid at the best of times, and in the current environment there is effectively no secondary market for sellers of credit. We take comfort in the fact that the Fund has been positioned well for the current environment. We have been structurally decreasing credit exposure in the Fund for the last number of years. This was on the back of spread compression and credit trading on the expensive side, with the lack of availability of credit assets pricing at favourable levels in the SA market. There has been a large mismatch between the demand and supply side of credit in SA for quite some time, and we believed it was more prudent to step aside and not invest in expensive assets. We have also as such endeavoured to increase the quality of credit held in the portfolio. The credit allocation which we indeed still hold in the Fund is thus limited and of a high quality. The weighted average credit rating of the entire Fund is AA, while the weighted average credit rating of the credit portion is A+. The following graph shows how our allocation to credit has changed over time and decreased over the last few years:

We believe the Fund is currently on a very good footing from a positioning point of view. The liquidity in the Fund and higher quality nature of the assets held in the portfolio is how one would want to be positioned given the weak macroeconomic environment we are likely entering. In addition, the Fund has ample scope to take advantage of higher interest rates, given the relatively low duration, and ample risk budget to take advantage of opportunities, should such opportunities arise and should the outlook improve.

Outlook

It should be no surprise that we believe the local and global macroeconomic outlook is decidedly uncertain at this point. What we are able to comment on, however, is the current positioning and potential forward-looking returns of the Fund. The Fund’s yield is currently just shy of 8% at around 7.9% (on a gross of fee basis). This may sound low given that nominal bonds are currently hovering around 11%, but it is important to also remember that the SA policy rate is currently at 5.25% with the vast majority of assets in the Fund invested in Jibar-linked assets. It’s important to also consider the duration component in addition to just the running yield of the Fund. The Fund currently has a modified duration of around 1.1 years. Let’s round that number to one year for ease of calculation. Should SA rates thus decrease (or rally) by 100 points, one would stand to make an extra 1% return on a forward-looking basis. Should the SA yield curve normalise back below 10%, then the Fund could potentially post returns towards the upper end of single-digit territory.

We believe the forward-looking return prospects of the Fund are particularly attractive at this point. In fact, the outlook is among the most attractive it’s ever been for the product, while at the same time we are running much lower risk in the portfolio than we historically have been. At the moment, one is thus potentially getting the best compensation on an outlook relative to underlying risks (compared to what has historically been the case).