JAMES TURP: Tactical ideas for fixed income in an election year

Income funds at the shorter end of the yield curve provide a cushion against surprises in an environment of pre-election uncertainty and weak economic growth. 

Last year turned out to be a good year for most fixed-income investors, though it was not all smooth sailing. There were various risk events, such as #LadyRussiagate, the docking of the sanctioned Russian cargo ship at Simon’s Town Naval Base in May, which led to concerns about SA’s support for Russia in its war in Ukraine.

After a difficult three quarters, bonds experienced a strong fourth quarter, which boosted income fund returns to 9.5%-12%, depending on risk allocations. 

The market tells us that 2023 was the end of the rate hiking cycle, and SA’s repo rate has been unchanged at 8.25% since May. It is indicated that the trend for interest rates has changed with current pricing suggesting no interest rate cuts in the foreseeable future. In our tactical investment strategy for 2024, we need to factor in the local general elections on the May 29 as well as the US November 5. 

The finance minister’s national budget speech, which took place in February, had very little market impact. The use of foreign exchange reserve profits to create short-term funding relief was received with mixed feelings. Eyes now turn to the elections, which may cause market volatility, depending on the results. 

Comments by the SA Reserve Bank seem to indicate that rate cuts will not precede the election. The Bank’s initiative to create a lower inflation target also makes it seem unlikely it will move before it is confident of the inflation trajectory.

This plan was recently backed by the National Treasury. By lowering the inflation target for monetary policy from its current band of 3%-6% to a possible point target of 3% or 4%, the Reserve Bank will entrench lower inflation expectations, which should result in longer-term sustainably lower policy rates. 

SA bonds have not meaningfully outperformed cash for several years. Fiscal metrics have deteriorated as the government has needed to borrow more in an environment of weak economic growth, which has driven bond yields higher.

At present, bond yields for 10 years and longer are returning 12.5%-13%. If inflation can stabilise and move lower, real returns from bonds will be hard to ignore. But for the time being our lower-risk portfolios have been delivering the best returns. 

Financial markets are vulnerable to surprises and this makes it difficult to take long-term exposure to the yield curve unless it is managed within a portfolio. Until we see progress in creating balanced and sustainable economic growth, the market will be susceptible to risk events.

Given expectations of lower rates later in 2024, cash-plus and multi-asset income type fund offerings are looking promising. For example, income funds (a unit trust in the cash-plus segment) aim to return yields above money market funds while creating an interest rate exposure similar to that of a one-year fixed deposit.

These types of funds have consistently outperformed fixed deposits in all rate cycles. If interest rates are cut in the second half of this year the floating rate portion of these funds will gradually reduce the yield by year end. If rates increase due to unforeseen risks in the market, the yield will rise as it holds a high portion of floating rate assets.   

Funds that invest in “big five” local bank assets and government bonds and offer cash-like liquidity for any unexpected cash calls are an attractive feature in an environment of uncertain economic growth. If SA’s economic outlook improves, the funds will benefit from lower interest rates along the steep interest rate yield curve. 

• Turp is head of investment strategy for fixed income at Sanlam Investments.