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Despite the political noise South African investors witness nearly daily and the fact that the economy is technically in recession, the current environment for fixed income investors is positive, according to Ian Scott, head of fixed income at PSG Asset Management.
“While a recession is negative for the economy, it means there is a low probability of rising inflation and hikes in short-term interest rates – which are negative for most fixed income assets, with the exception of inflation-linked bonds,” says Scott.
Over the last year, most fixed income asset classes have rewarded investors with above-inflation returns.
Cash returned 7.6% and government bonds returned 7.9%. The global environment is very supportive of local currency bonds and foreigners have entered the local market as substantial buyers.
In addition, credit spreads for large banks are falling, indicating good demand for credit in quality names.
Inflation-linked bonds returned -0.1% over the last year, due to the current downward phase of the inflation cycle.
Inflation over the past year was 5.4% and has surprised on the low side in 2017 to date. This, coupled with the negative growth environment, prompted the South African Reserve Bank’s (SARB) Monetary Policy Committee to cut the country’s repo rate by 25 basis points on 20 June.
However, the SARB has largely erred on the side of caution, delaying interest rate cuts for longer than expected.
“We believe this creates good opportunity for investors to invest in instruments offering high real yields at low levels of risk.
The market is giving us a window of opportunity that may change soon,” Scott says.
He says that PSG Asset Management is still finding good opportunities in cash markets.
In particular, banks are paying high yields in the front end of the curve to comply with banking regulations.
“We also continue to find opportunities for high real yields in the one-year and longer parts of the negotiable certificate of deposit market.
We think selective credit names are attractive, but the recent increase in demand for bank credit has seen spreads narrow and we believe the opportunities in that sector are less than a year ago.
As such, we are searching for opportunities in other areas of credit issuance.”
Scott says government bond yields are still attractive in the medium- to longer-dated area of the yield curve, despite current political noise.
“We believe that building a portfolio around a single negative narrative in bonds would expose our investors to risk if the narrative does not play out. We avoid such binary positioning.”
In addition, Scott notes, the valuations of long-dated bonds are not merely dependent on macro drivers. Factors like the strength of South Africa’s institutions, fiscal policy and term premium play a significant role as well.
“We believe a lot of negative news is already reflected in the yields of longer-dated bonds. If the SARB and National Treasury maintain the current policy framework, real yields of more than 3% on these bonds are attractive in a low growth and inflation environment.”
The asset manager has been allocating capital over the various interest rate curves where they have presented high real yield opportunities.
“Firstly, the long end of the cash curve – where banks are willing to pay higher yields for longer-term funding – remains attractive.
We have also selectively added to our government bond position in the front end of the curve. Finally, we participated in credit issues where credit spreads met our fair value criteria.”
Ian Scott is head of fixed income at PSG Asset Management.
