Navigating the inflation inflection point: How the PSG Diversified Income Fund rises to the challenge - Angles & Perspectives Q3 2022

Navigating the inflation inflection point: How the PSG Diversified Income Fund rises to the challenge

Inflation is undoubtedly hastening the unwinding of the global imbalances that have become characteristic of markets over the past decade. Despite the significant disruption we have seen in markets to date, we believe there is still some way to go towards normalisation. How are fixed income investors to navigate the inevitable market uncertainty we see ahead, as capital is reallocated to areas more suited to the new environment, while still targeting high levels of capital preservation?

The future environment will look different to that of the past
As pointed out in Head of Research Kevin Cousins’ article The new emerging markets? we believe there has been a fundamental and long-lasting shift in the macroeconomic playing field afoot. We also believe the winners of the future will look substantially different to those of the past. Given the environment we see ahead, we believe the ability to dynamically and flexibly allocate capital to these new winners/ideas will differentiate funds in the years ahead. For fixed income investors, this will require a careful balancing act between maximising returns and managing risk. However, in looking to meet the challenges ahead, we believe some things should remain constant:

• a philosophy that seeks mispriced quality, buying only at a sufficient margin of safety
• experienced individuals with the right behavioural temperament for market uncertainty
• actively seeking diversification, for the right reasons

We believe that the PSG Diversified Income Fund is well positioned to meet its objectives, bearing in mind that there are always risks attached to being exposed to markets (as outlined in the minimum disclosure document). The fund seeks to generate high income returns while targeting high levels of capital preservation, offering a safe pair of hands through inevitably uncertain markets. Below, we unpack how it does this in more detail.

Focus on buying mispriced quality
We see significant pessimism (foreign selling, lack of trust in Government) and very attractive real yields when it comes to investing in government bonds and negotiable certificates of deposit (NCDs). We deploy capital to our best ideas, and duration through government bonds has offered attractive real returns for many years. In contrast, we have found corporate bonds less attractive, particularly since the start of 2019. To invest in credit risk (corporate bonds), we require credit spreads to compensate for our evaluation of default risk. We believe the odds of mispricing in the corporate bond space has steadily reduced since 2019, as strong demand for fixed income products has led to ever more expensive corporate bond pricing. Further, when compared to global credit spread trends as outlined in The safer bet amongst South African fixed income assets, SA credit clearly is not as attractively priced. As a result, we have been steadily selling down our corporate bond exposure since 2019, and are unlikely to add high conviction to corporate bonds in the near term at current spreads. Our funds are therefore largely exposed to government bonds, where we see high odds of attractively mispriced value.

Diversification of risk with cheap assets
Diversification within a portfolio is important and understanding correlations is key to getting this right over time. Typically, a great diversifier away from SA risk lies in buying offshore cash and/or US bonds. In our funds, we are happy to hold offshore cash as dry powder and for its diversification properties. In risk-off environments these bonds typically strengthen alongside a weaker rand/US dollar exchange rate, resulting in a great buffer against SA risk. Over the course of this year, we’ve seen this relationship break down due to a revival of inflation and as these assets are expensive. As a result, despite the dollar strength, a strategy of diversification using developed market bonds would have worsened portfolio performance.

We have, however, been fortunate in SA to have attractive real yields in both nominal (fixed rate) and inflation-linked assets at a time when the largest risk consideration has been the inflation debate. We aim to ensure that we get the balance between inflation-linked and nominal exposure right, and over time it has been beneficial to have exposure to both asset classes in varying degrees as markets evolve. With the return of inflation to global markets, we have found that being able to shift between inflation-linked and nominal bonds favourably added to portfolio returns and the portfolio risk profile. Prior to Covid-19, inflation-linked bonds largely responded to fiscal risks, as inflation was not a major concern. The return of inflation to markets has meant these have offered diversification benefits against the major risk this year – being higher, persistent and volatile inflation. In environments where conditions are changing frequently, it’s important to remain open-minded and to adjust views as information changes. The graph below shows our willingness to use dynamic allocation to the advantage of our investors.

Liquidity equals flexibility in a fast-changing market
Liquidity is valuable through cycles, but particularly so during periods of market distress when the ability to adapt can be invaluable. In managing the fund, we always ensure we have sufficient liquid assets or outright cash to buy into market weakness. When allocating capital to less liquid assets, we often ensure there is an additional hurdle/premium for locking in client capital.

In the graph that follows, we illustrate a high-level analysis of the fund indicating a few key features that have proved and will continue to be valuable. One such feature has been a gravitation to more liquid assets, as we rotated out of corporate bonds into government bonds and NCDs. Having high levels of liquidity has enabled us to buy into weakness such as during the June and September 2022 market sell-offs. Currently, the fund has close to 15% in direct cash, which we are able to deploy into higher-yielding securities.

The final asset allocation considerations are whether we can introduce protection and balance to the portfolio. Our simple process considers total fund risk and the cost of protection, and whether we can mitigate certain tail events. We view the PSG Diversified Income Fund’s ability to invest in offshore assets as a particular strength when it comes to portfolio diversification. While the fund has not utilised these assets in recent years due to poor valuations, the ability to leverage off a wider toolkit of bottom-up researched global investment ideas across asset classes ensures any assets introduced into the fund are bought at a wide margin of safety and support the ultimate goal of capital preservation for our investors.

The result
By maximising the toolkit in the investors’ portfolio, we believe we are able to construct a fixed income portfolio that can form a core holding where clients are exposed to:

• mispriced securities
• an investment team that is consistent in tough markets
• inflation-beating returns
• asset allocation decisions that are handled dynamically at the fund level

The PSG Diversified Income Fund has followed this diligent process over long periods of time, and clients utilising the fund have benefited from significant inflation-beating returns of on average inflation + 2.9% p.a. after fees (A-Class) over rolling 2-year periods since the establishment of our process in 2014. Further, a diligent focus on downside protection has produced this result with long-term supporters of the fund only experiencing two negative rolling 3-month returns (both during the Covid-19 correction) with no permanent capital loss.

PSG Asset Management.