Low interest rates affect yields from income funds
South African interest rates have declined significantly in recent years. From December 2008 till July 2012, the South African Reserve Bank (SARB) has lowered the benchmark repo rate from 12% to 5%. This cumulative decline of 7% drastically impacted income fund yields. As a result, investors could no longer earn the 8% per annum income yields they were previously accustomed to without taking on inappropriate levels of credit risk.
Rising rates could lead to capital losses
The credit quality of the assets held in the Nedgroup Investments Flexible Income Fund has remained sound at all times. Investors achieved good total returns over time (as shown in the table) as capital gains counterbalanced declining income yields. Bonds, property and inflation-linked bonds delivered capital gains in a declining yield environment. The Fund also benefited from its offshore exposure as the rand weakened. Looking forward, circumstances are shifting in the opposite direction as rising interest rates are increasing the yield of the Fund, but this could lead to capital losses on assets like bonds that are sensitive to higher rates.
Rising rates, high liquidity and widening credit spreads enhanced yields
The Flexible Income Fund benefited significantly from exposure to floating rate assets since the beginning of the year. Yields from these assets adjusted upwards when Gill Marcus raised rates in January 2014 for the first time since she took tenure as Governor of the SARB in 2009, initiating the hiking cycle. In addition to the rising base yield, rising liquidity premiums and credit spreads also contributed to enhanced yields.
1) Rising rates: an inflection point
The US Federal Reserve (Fed) has embarked on three quantitative easing (QE) programmes since 2008, with’“QE3’ being an open-ended programme of monthly bond purchases. The flood of liquidity from these programmes found their way into emerging markets, including South Africa. The ultra-low interest rate policy of the US and other developed markets was exported to the developing world. A reversal of this liquidity began in June 2013, when then Fed Chairman Ben Bernanke announced the tapering of QE3. Until this point, it was uncertain when and if QE would end. Tapering resulted in the tightening of liquidity, which led to a massive sell-off in the rand and South African bonds, forcing the SARB to begin the rate hiking cycle in January 2014.
The SARB raised rates by 50 basis points to 5.5%, followed by a further 25 basis point hike in July. The chart below shows the real (after inflation) repo rate since 2001.
The real repo rate has been negative for the past three years as inflation has been close to the 6% upper bound of the inflation target, while the repo rate has averaged 5.25%. Since 2001, the average real repo rate was 2.4%. The global low yield environment means that rates may not have to rise to the same extent that they did in previous cycles. However, they still need to move up to positive real levels to attract the flows necessary to finance our fiscal and current account deficits.
2) Improving liquidity premiums
The ways in which we enhance our returns include earning liquidity and credit premiums. We capture additional yield by investing in three-year floating rate paper, as opposed to three-month paper, which we would roll on maturity. The following chart depicts the liquidity premium as measured by the spread on three-year floating rate notes on senior bank debt.
The spread has moved up from 0.55% to 0.85% since the beginning of the year. This 0.3% rise in liquidity premium plus the 0.9% increase in three-month Jibar has meant that the yield on floating rate notes has increased by 1.2% since the beginning of the year.
3) Widening credit spreads
The ultra-low level of interest rates in the last three years resulted in a desperate chase for yield in the local credit market. Since 2012, spreads compressed to levels that did not compensate investors for assuming the risk of default. For this reason, we have maintained an exceptionally high level of credit quality over the period. We have a maximum exposure of 3% at the A rating level and the rest of the fund exposure is rated AA or higher.
Rising interest rates and the recent African Bank default has triggered a long overdue re-pricing of credit spreads in the market. A few months ago, corporates were finding their new bond issues massively oversubscribed, but recent auctions have seen much less bidding support, while spreads are at least 20 to 30 basis points higher. Secondary market activity has also provided opportunities to purchase bonds at 50-80 basis points higher yield than where they were trading a few months ago.
We will continue focusing on yield-enhancing strategies
In managing the Flexible Income Fund, we continue to focus on yield-enhancing strategies in the money market, credit, preference share, convertible bond and offshore space. As interest rates adjust upwards, yield (rather than capital gains) will drive the returns in the Fund. Floating rate assets include cash, floating rate notes and bonds, offshore money market, hedged fixed rate bonds and preference shares. These assets comprise the core holdings of the Flexible Income Fund with a combined weight of over 90%. The yield on the core of the portfolio has already increased by 1.25% to 1.5%, due to a combination of rate hikes and increases in the liquidity premium and credit spreads. There is potential for a further uplift in yield as South Africa’s rate hiking cycle progresses and global interest rates normalise.