The recent spate of interest rate cuts may leave fixed income investors concerned about the future returns they can expect from their portfolios. However, historically, income funds have continued to deliver both inflation-beating (real) and above-cash returns – even after interest rates have been cut. While we remain optimistic on the outlook for fixed income investors over the medium term, we caution investors that opportunities are not evenly distributed. Now, more than ever, investors should be very selective about what they are exposed to within the fixed income universe.
Typically, income funds perform close to cash in rising interest rate cycles, and significantly outperform cash in a falling interest rate environment. This outperformance of cash was evident in the previous rate-cutting cycles of the early 2000s, post the Global Financial Crisis (GFC) and currently, following the 3% cut in rates.
Graph 1: Income fund returns (STeFI) vs cash (repo rate)
Sources: Bloomberg, JSE Market Data, PSG Asset Management. STeFI is typically the benchmark of income funds, while the repo rate provides a proxy for cash returns.
A reminder of fixed income basics
Fixed income instruments’ returns comprise yield (income) and capital returns (driven by changes in yield). In rising rate environments, the yield component tends to deliver most of the returns to investors, with floating rate instruments delivering attractive and rising income yields. When yields fall (prices rise), on the other hand, the capital component of fixed income investments becomes a more significant contributor to total returns and can be very attractive for investors. The sensitivity to changes in interest rates is referred to as the investment’s duration. The higher the duration of the asset, the more exposure the investor has to this capital contribution and potential upside. We believe that, partly because of the negative sentiment surrounding SA and partly because of where we are in the rate cycle, current yields, inflation rates and market conditions favour good return prospects.
We believe the current opportunity mirrors that of the post-GFC environment
In the wake of the GFC:
- Cash rates (repo rate) were cut by a significant 5% over a 1-year period, from 12% to 7% in 2009.
- Income funds outperformed cash by a significant 4% as rates were cut, similar to the current level of outperformance.
- The period of outperformance lasted approximately 61 months (5 years) to December 2013.
- During the 2008 rate-cutting cycle, inflation averaged around 8%, implying initially that investors outperformed cash but struggled to beat inflation. Inflation eventually bottomed at 2.1% in 2010, a level we are already seeing in the current environment – importantly, implying investors are already earning attractive real returns.
- After the sharp cut in interest rates in 2008/09, we saw bond yields fall to very low levels (the 10-year bond dropped to a yield of nearly 6%) and credit spreads compress sharply, driving strong performance of fixed income assets.
Although we are cognisant of the riskier fiscal backdrop, we believe that investors should not ignore the similarities in the cycles. We believe the attractive real yields of 4% to 7% above a normalised headline inflation rate of 4.5% (a conservative measure relative to the 2.1% inflation levels we are currently seeing) available in nominal and inflation-linked sovereign bonds can deliver similar outperformance to that seen in previous rate cycles.
Fixed income investors should focus on the risk/return trade-off
While attractive yields remain available to discerning investors, the opportunities are not equally distributed, with credit and money market-type instruments yielding close to, if not below inflation. Investors who flock into the shorter-dated end of the market, or who ignore material risks in the corporate credit market, may find their expectations will not be met. Investors should be aware that volatility is likely to remain a feature of the more attractive nominal and inflation-linked sovereign bond area of the fixed income market as risk appetite and sentiment fluctuate. We are cognisant that the fiscal environment has deteriorated significantly over the past 10 years, as evidenced by SA’s rising debt burden. However, it is important to remember that inflation is a key driver of bond yields (as in previous rate cycles). With inflation currently at 2.1% and an accommodative monetary policy stance, we believe the real yields offer significant compensation for the current visible fiscal risks South Africa is facing. In addition, from a valuation perspective, the premium offered to invest in SA bonds is globally attractive.
Our portfolio construction is supported by
our trusted process
We take a through-the-cycle view of interest rates, focusing on securing real yields that we believe compensate for risks. When inflation is rising (and available real rates are low), we believe it is appropriate to have a portfolio with low exposure to duration. Conversely, we look to take advantage of longer duration assets when they offer compelling real yields, the rate cycle is favourable, and inflation is falling/low. We have been extremely selective in the fixed income market for a considerable time. We remain contrarian investors, who look beyond market noise and the prevailing narratives to find investment opportunities, and we have previously argued the risks in sovereign bonds are being priced into the market. This focus on removing emotion from the decision-making process, across all asset classes, remains central to our process and philosophy. We continue to focus on finding the best risk-adjusted investment opportunities and constructing portfolios with the client objectives in mind. We believe the current rates cycle and low inflation outlook present compelling prospects for income-seeking investors willing to look through the current noisy environment.
Lyle Sankar is a Fund Manager at PSG Asset