Culture in a society evolves, grows and adapts over time. Similarly, the investment culture in SA has undergone significant shifts of late. Equity returns have been pedestrian, with several significant shocks to equity markets. Investors have seen little reward for the equity risks that they have taken and fixed income assets are looking more appealing.
The SARB has doggedly fought inflation expectations down from 6% towards 4.5%, while the local economy’s deteriorating fundamentals have meant that the cost of borrowing has remained stubbornly high in order to compensate investors for SA’s increased risk profile. The convergence of these factors means that investors can now purchase bonds issued by any of the major banks in SA with a yield of 9%. For an investor that has walked a tiresome journey with equities, locking in a highly probable outcome of CPI+4.5% holds significant appeal. Many investors and their advisors have also developed a comfort level and familiarity with equities. Unfortunately, they are not as comfortable with fixed income and, in many cases, simply fear the unknown.
As with equities, it is possible to have high-risk fixed income strategies or very low-risk strategies. In fixed income, these risks are not always immediately apparent. We could quite easily construct a high-risk portfolio that actually produces a stable, predictable outcome every month, until one day it doesn’t. Conversely, we could construct a portfolio that is volatile on a MoM basis, but carries almost no risk over a 5- or 7-year period, making it more attractive for longer-term investment needs such as living annuities. We attempt to unpack these options here and to give our readers a sense of what to look for in distinguishing between different fixed income portfolios. We do this by comparing the Anchor BCI Flexible Income Fund with the Anchor BCI Bond Fund and by explaining what the risks associated with fixed income really are, and what purpose each of these funds serve.
In managing a fixed income portfolio, the fund manager has a limited number of levers that they can pull to achieve an investor’s desired outcome. The portfolio yield, duration and credit risk exposure are important for all fixed income funds. Some portfolios might also include exposure to currency risk, listed-property risk, equity risk and derivative risk. We look at each of these options in more detail below.
Fixed Income investments are essentially loans that pay interest to the investor with the loan being repayable at a future date. The simplest form of fixed income investment is a bank deposit with which everyone is familiar. The portfolio yield is essentially the average interest rate that investments in the portfolio are earning. This represents the yield that an investor expects to earn on their investment (before deducting the portfolio manager’s fees). The yield serves two purposes, first it is the primary source of returns for the investor and second, the interest margin provides a safety cushion in terms of capital preservation. If the portfolio yield is 9% p.a., then the investor can reasonably expect to earn 9% (less management fees) on their investment every year.
If we assume that we have two portfolios, one with a yield of 7% and one with a yield of 9% then, after one year, the investor in the 9% yield portfolio would expect to have a greater return on their investment. Assume now, that both portfolios suffer an unexpected loss of 7.5%. After the first year, the investor in the 7% portfolio has earned 7% interest income and lost 7.5% through an unexpected event. Net, this investor has lost 0.5% through the investment. Conversely, the investor in the 9% yielding portfolio has earned 9% interest income and lost 7.5% through the aforementioned, unexpected, event. However, in this case, the investor has still achieved a net gain of 1.5% on the investment. Although this gain is unsatisfactory for the investor, they have nevertheless avoided losing their capital. Clearly, the higher yield has assisted the investor with capital preservation.
At Anchor, we place a significant emphasis on maintaining a high portfolio yield for our investors. The Anchor BCI Flexible Income Fund is currently being managed to a portfolio yield of between 9.00% and 9.35%, whilst the Anchor BCI Bond Fund’s current portfolio yield is 9.70%.
Most readers will be familiar with the interest rates that banks offer on deposits. Often banks advertise different interest rates, depending on how long you are prepared to leave your money at any particular bank. Generally, the rate that banks will pay you for a six-month deposit is greater than what they will pay for a one-month deposit, because the bank has greater certainty of funding with six-month deposits. One might say that, by extending the duration of your fixed deposit from 1 month to 6 months, you are able to increase your portfolio yield. Fixed Income managers do exactly the same, except they have greater flexibility in terms of choosing the maturity dates of their loans. Currently, they can invest for any time period from today through to the year 2048.
It is important to note that you lock-in the interest rate on your deposit at the outset of the investment. This means that, if interest rates go up tomorrow, you are still locked into the lower interest rate at which you placed the deposit. As a result, you might find yourself locked into a deposit yielding lower-than-prevalent market rates. However, this in turn also means that, as interest rates go up, the value of this investment will go down because investors now have higher-yielding alternatives that are more attractive than your investment.
Duration is a rough measure for how long you are locked into interest rates. The duration on a one-month fixed deposit is 1 month, whilst the duration on a six-month fixed deposit is 6 months. It is a little more complicated to compute the duration of bonds but, in essence, the longer the bond, the longer its duration.
Fixed Income portfolios publish their durations from time to time. At the time of writing, the duration on the Anchor BCI Flexible Income Fund was 0.5 years, whilst that of the Anchor BCI Bond Fund was 7.2 years. These durations have a very handy mathematical property. If domestic interest rates suddenly increase by 1%, then we would expect the Flexible Income Fund to lose 0.5% as a consequence (duration of 0.5 years times 1% rise in rates = 0.5% loss). The Bond Fund, on the other hand, will see a loss of 7.2% in the same scenario (a duration of 7.2 years times a 1% rise in rates = 7.2% loss).
This measure of exposure is not perfectly precise but it is a very reliable rule-of-thumb to understand a portfolio’s exposure to rising interest rates. Remember, the investor will earn the portfolio yield minus duration losses in this case.
Therefore, if rates rose by 1% tomorrow, then the investor would, over the course of the next year, have earned a return on the Anchor BCI Flexible Income Fund of 8.50% (9.00% portfolio yield minus the 0.5% duration loss), whilst in the Bond Fund the investor would have earned 1.5% (9.7% portfolio yield minus 7.2% duration loss). Investors in both funds would nevertheless still need to deduct the management fees, however, it is true that over a one-year period investors in these funds would not have experienced a capital loss.
Another useful property of duration is that losses from duration are earned back over the remaining life of a bond. Therefore, the Anchor BCI Flexible Income Fund might lose 0.5% on the day that the rates are hiked but would expect to earn most of this back over the next 0.5 years or six months. The Bond Fund would lose 7.2% on the day that interest rates rise but will only earn this back over a much longer timeframe. If your investment time horizon is 6 months, then you do not care about the duration in the Anchor BCI Flexible Income Fund because any losses today will be largely earned back within 6 months. Alternatively, if you are investing for a longer term, for example 8- to 10-years in your living annuity then you don’t care about the duration in the Anchor BCI Bond Fund because the duration losses will be earned back before you need to access your capital. In this case, you may benefit from locking-in the higher yield available in the Bond Fund and accepting market volatility, knowing that by the time you need your capital, it will have worked itself out.
We have seen with African Bank that when you are lending someone money, there is a risk that they will become bankrupt and unable to repay the loan. This will result in a permanent loss to your portfolio. Portfolio managers will gauge the riskiness of each business to which they lend money – clearly a loan to Eskom is far riskier than a loan to FirstRand. As a result, Eskom has to pay a significantly higher interest rate to investors than FirstRand in order to compensate those investors for assuming the greater risk of non-payment. In SA, the riskiest loans are paying c. 15% interest rates, whilst the lowest risk loans are paying about 7%. This means that it is very easy for a portfolio manager to invest in risky loans and offer an attractive portfolio yield, but with a far greater risk of capital loss. At present, most blue-chip corporates are paying interest rates of 8.25% to 9.5% in the bond markets. Thus, you should be cautious of portfolio yields above 10%, as the credit risks are not necessarily obvious.
There are two defences against lending money to someone who then becomes bankrupt. First, a portfolio manager is paid to understand to whom they are lending money. At Anchor, we have an established team of analysts who meet with management and know the companies well. These analysts are key to understanding, at the outset, what risks an investor might face. Their ongoing scrutiny is vital as they identify early warning signs allowing us to take remedial action, usually by selling the bonds of the affected company on the bond exchange.
The second defence is to diversify a portfolio in such a way that if we do find a bad apple in the basket of investments, its impact, while unpleasant, is small enough that our investors will not suffer a catastrophic loss. We have a highly developed set of portfolio construction rules and risk metrics that seek to minimise the impact of any single corporate bankruptcy.
With regards to the Anchor BCI Bond Fund and the Anchor BCI Flexible Income Fund, our first line of defence is our team of analysts that are very familiar with the companies which they cover.
Should an unexpected event occur, we know that a default at any corporate means investors might need up to 3 months of interest income to recoup their losses. While this is not ideal, it is also not catastrophic
Unfortunately, there are only five large banks in SA, and we find it necessary to have significant exposures to ABSA, FirstRand, Investec, Nedbank or Standard Bank. All these banks are well capitalised and well run. We, like most South Africans, are comfortable placing a client’s cash at any of these banks even though it means we have potentially larger credit exposure to the banking sector.
From a credit perspective, anyone with an investment horizon of one year would find it incredibly unlikely that they will suffer a capital loss in either the Anchor Flexible Income Fund or the Anchor Bond Fund.
Some fixed income portfolios invest in currencies other than the rand. This can be a significant source of volatility in portfolios. While a little currency exposure can bring significant diversification benefits to the portfolio, too much foreign currency exposure will detract from the portfolio yield and make returns volatile, often with periods of great performance and then times of stark underperformance.
The Anchor BCI Bond Fund has no currency exposure, whilst the Anchor BCI Flexible Income Fund unusually has between 2% and 5% exposure to the US dollar (currently 2.6%). This is designed so that even if the rand experiences runaway strength down to R10/$1, the impact on the investor will be 0.8% currently and, even in a worst-case scenario only 1.7%. Again, this will be cushioned by the portfolio yield.
Many of the multi-asset income portfolios include listed property and listed equity. Portfolio managers do this in order to take advantage of the diversification benefits of including multiple asset classes. This works well over time although, as we saw last year, if listed property misfires, then it acts as a drag on the portfolio. As with currency exposure, a small amount of listed property does bring useful diversification benefits. The Anchor BCI Bond Fund may not invest in listed property, whilst the Anchor BCI Flexible Income Fund currently holds 2.5% listed property exposure. Again, it is enough to bring some diversification, whilst being small enough that if the sector misfires again our investors will not be catastrophically impacted.
There are several portfolio managers that use derivatives, including futures and options to take small speculative positions in their portfolios. The jury is out in terms of whether this creates a long-term benefit for investors. We are of the “simpler is better” mindset and we avoid complex derivatives and intricate investment structures in the Anchor Fixed Income portfolios.
Hopefully, we have given readers a background into what the key risks are in fixed income portfolios and around how to think about these options in the context of assessing different fixed income portfolios.
We are often asked by clients what the risk is of a capital loss in either the Anchor BCI Bond Fund or the Anchor BCI Flexible Income Fund over a period of three years or longer. Having worked through the key risks in fixed income and understanding the strict portfolio construction metrics being applied, one will conclude that to suffer a capital loss over a period of three years or longer is almost impossible in either of these portfolios.