Governments around the world have been jarred into action, as the contagious and deadly COVID-19 virus has turned into a global pandemic. The authorities have begun imposing severe restrictions on peoples’ movements in an attempt to isolate and limit the speed of the contagious infection. This has resulted in an abrupt slowdown of industries around the globe, with the most acutely impacted sectors being tourism and leisure. The rapid slowdown has dented companies’ revenues and challenged the viability of businesses with weak balance sheets. Combined with the recent Saudi induced oil price collapse, the result has been sharp sell-offs across multiple markets, including commodities, debt and equities.
Despite the severe sell-offs in global markets, we have remained focused on the consistent application of our investment process. The crux of which is to ensure an ongoing understanding of the intrinsic values of the quality assets on our buy-list, and to adjust portfolio weightings where prices deviate materially away from intrinsic value. This same process transcends all asset classes at Northstar – it is applied to the management of the fixed income assets as well as the equity assets.
Fixed income valuations
Despite declining inflation expectations (less than 5% YoY) and a sharp decline in interest rates (repo rate cut of 100bps to 5.25%), local bond yields have spiked to elevated levels as the market attempts to price in the risks of the sharp global economic slowdown (COVID-19) and the imminent Moody’s downgrade to junk status as a result of a decade of poor government leadership and fiscal decline.
Before the COVID-19 outbreak, bond yields had risen to above fair value, taking into account the risks of a credit downgrade to junk status. For example the SA 10y bond (R2030) was trading at 9% vs our fair value yield of 8.75% at the start of 2020. As such we were positioned with a neutral modified duration versus our strategic benchmark.
Subsequently, yields have risen by a further 3.5%, in an environment where interest rates have been cut by 100bps and the oil price has fallen by more than 50% ($60/barrel to $24/barrel), factors which would normally be hugely supportive of bond valuations. However, these events have unfolded in a climate of extreme uncertainty, and investors have panicked and sold down their investments, regardless of valuations.
We believe the market is being overly pessimistic in its pricing and with the SA 10y bond (R2030) trading on a 12.5% yield, offers investors an attractive 7.5% real return.
The same attractive valuations apply to SA inflation linked bonds with the 5 year (I2025) trading on a 5.5% real yield.
SA Listed property
The picture is not as clear for the SA listed property stocks, which are also trading on dramatically elevated yields. In this instance, the distributions are less secure given their reliance on tenants being able to pay their rents. An impossible feat when businesses grind to a halt. Consider for example forced closures of shopping malls due to the lockdowns around the globe. The problem is further exacerbated by property oversupply, generally weak balance sheets and the poor economic backdrop, even before taking into account the COVID-19 shock.
In the absence of any political or commodity related factors, which do have an influence on the level of the Rand, it can be argued that the local currency was already undervalued by 12% on a purchasing-power-parity basis at the start of the year, when the Rand was trading at 14 to the Dollar. At that point, the Northstar Income Fund was slightly underweight global currencies with an exposure of 12.5% vs. the benchmark weighting of 15%. The Rand is currently trading at 17.60 to the US Dollar, which on the same basis represents a 30% undervaluation vs the US Dollar, levels only reached 5% of the time going back 20 years, when SA first began inflation targeting. Despite the prevailing extreme uncertainties, due to the recent COVID-19 outbreak and political challenges, there is a strong argument for raised exposure to the Rand. In this regard, the global currency exposure has been steadily reduced to the current weighting of 4.5%.
Extreme uncertainty is driving global markets, with all assets experiencing sharp and severe sell-offs due to liquidity squeezes. All nodes of apparent liquidity are being tapped, which has even resulted in the drying up of the US treasury market. Locally, government bonds have not been spared with an almost instantaneous 3.5% rise in yields which has translated into an approximate 25% drop in capital values. The size of the latest impact is dwarfing the metrics last seen during both the global financial crisis and the infamous Nene-gate saga. On a positive note, the Northstar Income fund has an extremely healthy liquidity profile, with 13% on call, 21% in government bonds and 4.5% in global currencies, which is immunising investors against any permanent capital losses.
This leaves a balance of 61% exposed to corporate related credit risk. Of this portion, a significant 53% is held in senior bank paper, spread across the four majors. The balance is a 5.5% weighting to senior A-grade corporates and 2.5% exposure to subordinated debt. The portfolio has zero exposure to tier 1 and tier 2 paper, which is the likely area of the credit market to experience distress during a credit event.
We have selectively been gaining exposure to higher yielding government fixed bonds, reducing exposure to corporates in favour of government paper and gradually reducing our exposure to global currencies. The net result has seen the yield in the Northstar Income Fund rise from 7.5% to close to 9% and the weighted average maturity has increased slightly to 4.9 years. The portfolio remains well exposed to liquid assets which allows for further opportunistic positioning should this market correction intensify.