The role of fixed income in achieving long-term return objectives

By Jannie Leach

The Nedgroup Investments Core funds provide the investor with low-cost exposure to a range of local and global asset classes. 

In a previous newsletter we covered how obtain sensible exposure to South African equity[1]. In this newsletter we cover the importance of fixed income in helping these funds achieve their long-term return objectives.

Cash is no longer king

Over the past few months we have seen a steepening of the yield curve as interest rates have come down while bond yields have gone up. As one can see from the chart below, following the recent aggressive rate cuts, longer term government bond yields have become quite attractive relative to short-term rates, with the current 10-year government bond yield sitting at around 9%. This has resulted in many investors increasing their bond exposure; directly or through bond funds such as the Nedgroup Investments Core Bond Fund.  

While many investors have increased their bond exposure, the strategic weightings to this asset class in the Nedgroup Investments Core Accelerated, Nedgroup Investments Core Diversified, Nedgroup Investments Core Guarded and Nedgroup Investments Core Global funds have remained unchanged.

The role of fixed income in the Core funds

The Core funds were designed with reliability in mind and a significant amount of research went into setting their robust long-term strategic asset allocations. During this process special attention was paid to how asset classes behave during different parts of the market cycle to gauge their diversification value. We also spent time on the sub-asset classes such Real Estate Investment Trusts (REIT) and inflation-linked bonds to achieve broader diversification.

While it was clear that equities would provide the greatest long-term growth, fixed income plays an important role in creating more predictable outcomes over shorter investment horizons. The allocation to fixed income therefore depends on the return objective and investment horizon. The Core funds have the following return objectives and minimum investment horizons:

  • Nedgroup Investments Core Accelerated Fund targeting inflation +5 to 7% after fees over rolling 7 years
  • Nedgroup Investments Core Diversified Fund targeting inflation +4 to 6% after fees over rolling 5 years
  • Nedgroup Investments Core Guarded Fund targeting inflation +2 to 4% after fees over rolling 3 years
  • Nedgroup Investments Core Diversified Fund targeting US inflation +3 to 5% after fees over rolling 5 years

The table below summarises the latest strategic asset allocation weightings of the Core funds as well as their total exposures to fixed income.

In the table we can see that the fixed income allocation increases as the minimum investment horizon decreases, the Nedgroup Investments Core Guarded Fund has the highest allocation, and the Nedgroup Investments Core Accelerated Fund the lowest. The allocation to cash within fixed income also increases the shorter the investment horizon as bonds tend to be more volatile than cash, for example in the Nedgroup Investments Core Guarded Fund, cash makes up 30% of the 52.5% total South African fixed income allocation while in the Nedgroup Investments Core Diversified Fund it only makes up 7.5% out of the total 19.5% allocation.

The first three funds in the table all get their offshore fixed income exposure through the Nedgroup Investments Core Global Fund (UCITS), which allocates 27.5% to global fixed income. Global fixed income plays an important role during large market drops when South African equities and bonds become highly correlated to global equity markets.  In scenarios such as the market reaction in the first quarter this year to the COVID-19 pandemic, global fixed income, in rands, greatly assisted in reducing drawdowns in all the Core funds.  Year-to-date (23 June 2020) global fixed income is up by over 3% in dollars (27% in rands) while other global asset classes are down. In rands.

Implementation is key in fixed income

Investing in fixed income requires a special skill set as there is a  large part of this market that doesn’t trade frequently and therefore carries liquidity risks. Longer-dated government and corporate credit comes to mind. In order to deal with these challenges, you require a fund manager that has both the skill and the scale in assets to manage these risks adequately. Taquanta Asset Managers, currently manages our Core funds (Nedgroup Investments Core Accelerated, Nedgroup Investments Core Diversified, Nedgroup Investments Core Guarded and Nedgroup Investments Core Bond Funds) and our money market funds (Nedgroup Investments Core Income, Nedgroup Investments Money Market, Nedgroup Investments Corporate Money Market and Nedgroup Investments Prime Money Market Funds). They are the largest money market manager in South Africa and have the scale (over R200 billion in AUM) and experience to implement the Core funds efficiently. 

In the Core funds, Taquanta uses a patient and flexible approach to implementation by balancing tracking error versus the cost of trading. This is especially important in the bond space where they often deal with illiquidity in some of the bonds. Taquanta tends not to invest in basket trades, which can result in giving away a lot of yield, but rather follow the approach of buying one or two bonds with the desired duration so we don’t give any yield away. The combination of efficient bond implementation and yield enhancement on the cash allocations have added significant value to the long-term track records of the Core funds over past 11 years.

Nedgroup Investments Core Bond Fund

Investors who do their own asset allocation or seek additional bond exposure can access Taquanta’s fixed income skills through the Nedgroup Investments Core Bond Fund. Our philosophy when designing the Core Bond Fund was to achieve superior, risk-adjusted returns relative to its peers with lower fees by staying largely neutral on a modified duration. The fund charges a fee of 0.40% pa with a total expense ratio of 0.44% pa. The combination of low fees and being neutral on duration has resulted in top quartile performance since Taquanta started managing the fund in October 2012.

Conclusion

The fixed income allocation within the Core funds plays an important role in achieving their return objectives by reducing the probabilities of negative returns over their minimum investment horizons.  The global fixed income allocation provides additional downside protection through turbulent times and big market drops. The efficient implementation of fixed income has helped the Core funds ‘deliver what’s on the tin’ by providing greater consistency compared the peers and improve the probabilities of achieving their long-term objectives.

 



[1] How we how do you obtain sensible low-cost exposure to South African equities?” Q2 2018 Newsletter.