Quarterly Commentary - Q2 2020

Market comment

Global financial markets staged an impressive recovery in the second quarter of 2020. Financial markets have held up extremely well given the unprecedented nature of the economic shock experienced globally. While strict lockdowns have been relaxed in many countries, the recovery in financial markets is more attributable to the extent of the stimulus provided by central banks and governments, and not necessarily because of a rapid improvement in the underlying economies. The International Monetary Fund confirmed this view in its recent publications and indicated that this phenomenon may increase the possibility of financial conditions tightening at some point in the future.

Increased risk appetite from investors and the liquidity available found its way into emerging market assets, which boosted asset prices post the sell-off in March. South African equity and fixed income markets were included in this basket. The domestic bond market was buoyed by a lower repo rate, lower inflation forecasts, the second phase of government’s policy response, and foreign investors selling local bonds at a much slower rate, despite the country exiting global indices such as the World Government Bond Index. The South African Reserve Bank (SARB) continued purchasing domestic bonds in the secondary market, in a sustained effort to support the market and prevent any further dislocations. However, it must be noted that the SARB has repeatedly emphasised that this is not a quantitative easing programme.

Domestic bonds underperformed in June, mainly due to the bad news contained in the supplementary budget. South African debt dynamics have worsened, and are deteriorating very rapidly due to the impact of COVID-19. Without intervention, the country could end up in a debt spiral (leaving debt-to-GDP at 140% before the end of the decade). However, National Treasury has made a commitment to rein in non-interest expenditure and return South Africa to a sustainable debt path. Increased bond issuance in the short to medium term is likely to lead to higher yields and a steeper bond yield curve.

The SARB’s Monetary Policy Committee (MPC) cut the repo rate by 150 basis points over the course of two meetings held in the quarter. The first, an emergency 100 basis point cut, was implemented in April post the extension of the lockdown, due to a large downward revision to growth forecasts. The second followed at the MPC’s May meeting, at which it revised growth even lower and forecast inflation to drop below 3% for the next six months (before normalising next year). These aggressive cuts were made mainly to relieve the struggling consumer. While further cuts are expected, they will likely be smaller. At quarter end, the forward rate agreement market was pricing in further cuts of close to 50 basis points for this year.

Portfolio activity and positioning

Although volatility has decreased over the quarter, opportunities in the bond and credit markets have emerged from the crisis. We have been taking advantage of these deliberately and slowly.

The bond curve has remained steep, with yields on longer-term bonds higher than those on shorter-term bonds. At quarter end, the curve was at a similar level of steepness to its level at the height of the COVID crisis. This has been the main area of opportunity for the fund. However, given recent positive performance from bonds, we were cautious not to increase duration (sensitivity to interest rate changes) too quickly. We took advantage of the steepness in the curve while keeping duration low by investing in asset packs (government bonds with swap overlays). The yield pickups from these asset packs are at far superior levels to those available in the credit space generally, as credit spreads continue to narrow.

Surprisingly, bank funding spreads are at all-time lows, and negotiable certificate of deposit rates are below government bond yields on the short end of the curve. This places the fund in an unusual position of finding government bond opportunities more attractive than having a reasonable money market position (which helps with liquidity). Although we are keeping a decent amount of liquidity in the fund, we are mindful of the negative real yield that cash is offering. Given the potential for the repo rate to be cut further, we will continue to increase the fund’s term to maturity. (It is hard to believe there was ever a time when the yield curve was inverted!)

Although credit spreads continue to narrow, we are very active in the secondary market and continue to search for attractive credit bonds while making sure we are comfortable with the issuer’s fundamentals. The credit market remains illiquid, particularly in the listed property and SOE sector where bid/offer spreads are extremely wide. Our exposure to both these sectors is negligible, as fundamentals have deteriorated significantly. We have rather upweighted the capital instruments banks have been issuing as well as insurance subordinated debt.

Our inflation-linked bond (ILB) exposure has not increased, as we are weary of government’s issuance plans in the ILB space (which may cause pressure on real yields) and of the subdued trajectory for inflation going forward. We have increased our weighting to listed property slightly but are extremely mindful of deteriorating fundamentals in this sector which have not yet fully played out.

The decision to increase modified duration and the term to maturity will impact fund volatility. However, we believe that this is the right thing to do for our investors. With real yields in shorter-dated instruments being negative, there are very few other options currently available for income funds. We are taking on more government bond risk but are being mindful of the volatility risk that fixed-rate bonds bring. It is important to remember that investing in government bonds is highly unlikely to ever result in a permanent loss of capital. Considering the yields these bonds are producing compared to cash, we see this as a down-payment for compelling future returns. The fund remains a top-quartile performer across all relevant time periods.

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Written by Bronwyn Blood

Portfolio Manager

Prior to joining Granate Asset Management in December 2015, she was the Portfolio Manager of the Flexible Fixed Interest Funds and the flagship Absolute Yield Fund at Cadiz Asset Management. When Cadiz bought African Harvest in 2006 Bronwyn took over the management of the Flexible Fixed Interest funds. Bronwyn holds a B.Comm (Honours) degree from the University of Natal.

Bronwyn Blood B.Comm (Honours)