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Opinion

Dynamic solution to changing market conditions

Dirk Jooste, Fund Manager, PSG Asset Management
June 3, 2021, 5:33 p.m.
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Word count: 702

While many investors may associate multi-asset funds with the higher-risk balanced funds, which can hold up to 75% in equities, there are also multi-asset funds with more moderate risk profiles and a lower allocation to equities. These funds offer a dynamic solution to changing market conditions, while remaining aligned to the stated fund objective.

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While many investors may associate multi-asset funds with the higher-risk balanced funds, which can hold up to 75% in equities, there are also multi-asset funds with more moderate risk profiles and a lower allocation to equities. These funds offer a dynamic solution to changing market conditions, while remaining aligned to the stated fund objective.

Multi-asset funds offer a compelling alternative to more cautious income-seeking investors, who are willing to tolerate some additional volatility. While these funds can traditionally add holdings from the various asset classes (equities, cash, bonds and property), we have noted the exceptional upside on offer from SA government bonds. As a result, our current holdings in both nominal and inflation-linked government bonds are trending substantially above their average long-term levels in our portfolios.

SA government bonds

We are well aware of the precarious fiscal position South Africa finds itself in. However, it is important to put the fears around the Government’s fiscal position into perspective. Our research suggests that the fiscal risk premium and bond supply premium (increased government funding requirements) embedded in SA government bonds are excessive. Curves are therefore steep when comparing the mid- to long parts of the curve to the shorter end. This provides an opportunity to enjoy high levels of yield and, given the elevated shape of the curve, investors will enjoy the benefits of a steep ‘rolldown’ as time progresses.

One niche area of the sovereign bond market that stands out as being particularly attractive at present, is inflation-linked bonds.

Inflation-linked bonds (ILBs or inflation linkers) are particularly attractive right now, for a number of reasons:

• Real yields above 4% for longer-dated instruments are high by historical standards (above the 98th percentile) and are among the highest in the world. 

• Total returns look very compelling relative to cash and fixed nominal bond alternatives, especially after adjusting for risk (no inflation or credit risk).

• Foreigners are not large players in this space.

• They provide valuable portfolio insurance in the seemingly unlikely scenario of a spell of elevated inflation or even the expectation thereof (a scenario that would be very challenging for traditional cash and fixed-rate nominal bond instruments).

• ILBs play a valuable role in the portfolio as they bring a significant all-weather dimension to multi-asset and fixed income portfolios by virtue of having an adjustable base rate mechanism. During periods of unexpected, elevated inflation this provides an invaluable counterbalance to many exposures in a portfolio. In times when other floating alternatives are unattractive, short-dated inflation linkers can be an efficient instrument choice.

While short-dated ILBs are a compelling alternative to cash and floating-rate credit today, we also find significant opportunity in long-dated ILBs.

Long-dated ILBs can be volatile given relatively high duration characteristics (price is more sensitive to changes in yield), but at sufficiently high starting real yields, they can begin to compete against equity alternatives, at much lower levels of risk.

In the corresponding graph we consider the expected range of outcomes for the FINI 15 equity index (a good proxy for SA interest rate sensitive equities) and a long-dated ILB maturing in 2050 looking forward over a one-year horizon. We consider four scenarios below. A bear case, in which we assume a return to the (all-time) low levels reached during March/April of 2020, a status quo scenario where there is no normalisation in rating, an upside scenario where the rating reverts to the 10-year average and, finally, a bull scenario where the 10-year 90th percentile rating levels are reached. Currently, the two investments have similar starting dividend/ coupon yields of 5.0% and 4.3% respectively. Assuming no change in rating and that capital grows in line with inflation (assumed at 5%), we arrive at very similar status quo returns. However, considering the range of outcomes on the down- and upside, we see very favourable asymmetry from the long-dated ILB – especially considering the risk-free nature of the investment.

The last year has seen a profound recalibration of the fixed income opportunity set. We have responded by reducing our cash and credit exposures and adding to nominal and inflation-linked bonds, where short-dated linkers are playing a valuable cash-type role and longer-dated instruments are providing equity-like expected returns at substantially lower risk.

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