The Northstar SCI Income Fund provides investors with a regular and stable income that targets inﬂation-beating returns over the long-term, while actively managing the risk of capital loss in the short-term. The Fund invests in high-quality fixed income assets comprising fixed coupon, floating-rate and inflation-linked bonds predominantly in senior A-rated paper as well as listed property, global bonds and global currencies.
While investors in the Fund require real returns and capital preservation over relatively short periods of time (one to three years), the interest rate cycle may take longer to unfold. In managing the Fund, we therefore follow a flexible asset allocation approach that takes advantage of the different characteristics of these assets at different parts of the cycle to generate outperformance for investors.
The long-term drivers of returns in the fixed income market are the price paid, the point in the interest rate cycle, inflation and changes to sovereign and credit risk. The impact of changes in interest rates and inflation on the various classes of fixed income assets are shown below:
Cash and floating rate notes do well with rising interest rates, especially when there is a comfortable margin between yields and the expected future inflation rate.
Falling interest rates favour fixed coupon bonds, particularly when the yield on these bonds are higher than the future inflation rate.
Inflation-linked bonds do very well when bought on high real yields and inflation expectations surprise to the upside.
The current macroeconomic outlook favours fixed and inflation-linked bonds
Our base case anticipates that South Africa’s sovereign risk will increase with large budget deficits, interest payments exceeding 20% of tax revenue and unstable debt-to-GDP projections. We expect growth to rebound more slowly than in the US and other countries, with lower tax collections, rising public wages and difficulty in implementing the policies necessary to address these issues. Interest rates are expected to stay on hold for the next 12 months, with inflation increasing from current levels of around 3% to settle at 4%, 0.5% above the current repo rate.
In this scenario, cash and floating rate notes will generate negative or very low real returns. The low interest rate environment will support fixed bond returns and rising inflation will benefit inflation-linked bonds. While longer dated inflation-linked bonds remain over-valued, inflation rising above the short-term breakeven level of 3.7% will result in valuations favouring the 1- to 7-year maturities. Rising sovereign credit risk is keeping the yield curve at historically steep levels with volatility likely to remain high at the long-end of the curve and valuations favouring the 6- to 11-year fixed bond maturities.
Other credit opportunities
Credit spreads represent the difference in yield between a South African government bond and another bond of similar maturity issued by corporates or other issuers. Fixed coupon bond credit spread opportunities are available in shorter-dated bonds, but spreads are compressed by historic measures. We find ourselves in an unusual situation where mid- to longer-dated fixed coupon bond credit spreads are trading in line with government bonds, offering no opportunities for yield enhancement in this credit segment. As a result, the Northstar SCI Income Fund is currently holding a higher than usual proportion of government bonds to take advantage of their low risk, high liquidity and equivalent yields.
Credit spreads on senior floating rate notes issued by South Africa’s banks are currently compressed (55bps – 130bps), resulting in very thin real yields. Spreads on Tier 2 and additional Tier 1 floating rate notes are also compressed (140bps – 240bps and 140bps – 400bps respectively), resulting in reasonable to decent real yields, but at elevated risk due to deteriorating loan quality and profitability in the banks.
Other fixed income assets
Preference shares have been negatively impacted by falling interest rates, resulting in lower prices, but these are not low enough to provide the necessary yields above our fair value hurdle rates. Property stocks were hit hard by the COVID-19 crisis, with certain segments (logistics) outperforming others (retail, commercial and office). Although prices have adjusted lower to accommodate the deteriorating fundamentals of impaired balance sheets and income streams, the high levels of economic uncertainty prevent us from allocating these assets to funds with short-term investment horizons.
Range of outcomes and possible left-field events
In assessing the investment opportunities on offer, Northstar considers a range of potential outcomes. In addition to the base case discussed above, our bull and bear cases are as follows:
Chart 4: Fixed coupon and inflation-linked bond yield curves vs one-year exit yields
Source: Inet Bridge, JSE & Northstar
Chart 4 shows the relative values of fixed coupon (blue line) and inflation-linked (turquoise line) government bond nominal yields against Northstar’s bear, base and bull case fixed coupon bond exit yields (grey lines) over a period of one year.
The chart shows good value in the 6- to 11-year maturity fixed coupon bonds and in the 1- to 5-year maturity inflation-linked bonds, where exit yields are expected to be lower than current yields. Because the value and yield of bonds move inversely, higher yields mean the bonds are available at lower prices.
The large red dot in the chart highlights the maturity (3.7 years) and yield (6.3%) for the Northstar SCI Income Fund, taking note that these metrics include the Fund’s 14% global cash holdings, which offset the majority of interest rate risk in the portfolio.
We believe that the Northstar SCI Income Fund’s asset allocation, curve positioning and credit exposure are appropriate given the current performance drivers and valuations, point in the interest rate cycle, prevailing macroeconomic conditions and fiscal dynamics. This positions the Fund well to continue to outperform its benchmark and meet the return objectives for our clients.