While many investors may associate multi-asset funds with the higher-risk balanced funds (which can hold up to 75% in equities), there are also multi-asset funds with more moderate risk profiles and a lower allocation to equities. These funds offer a dynamic solution to changing market conditions, while remaining aligned to the stated fund objective.
We believe that, considering the poor expected returns from cash and income assets, income investors who are able to extend their time frames slightly should consider how low-equity multi-asset funds can be used to address their income needs.
These funds offer a compelling alternative to more cautious income-seeking investors who are willing to tolerate some additional volatility. While these funds can traditionally add holdings from the various asset classes (equities, cash, bonds and property), we have noted the exceptional upside on offer from SA government bonds in particular, which we discuss in more detail below.
As a result, our holdings in both nominal and inflation-linked government bonds are trending substantially above their average long-term levels in our portfolios. It is precisely the ability of multi-asset portfolios to tailor their holdings of asset classes as opportunities change that make them so valuable as part of a diversified portfolio to fixed-income investors, and it is part of the reason we believe investors should consider them favourably at this time.
We are well aware of the precarious fiscal position SA finds itself in. However, it is important to put the fears around the government’s fiscal position into perspective. Our research suggests that the fiscal risk premium and bond supply premium (increased government funding requirements) embedded in SA government bonds are excessive. Curves are therefore steep when comparing the mid to long parts of the curve to the shorter end. This provides an opportunity to enjoy high levels of yield and, given the elevated shape of the curve, investors will enjoy the benefits of a steep “rolldown” as time progresses.
One niche area of the sovereign bond market that stands out as being particularly attractive is inflation-linked bonds (ILBs or inflation linkers), for a number of reasons:
- Real yields above 4% for longer-dated instruments are high by historical standards (above the 98th percentile) and are among the highest in the world.
- Total returns look very compelling relative to cash and fixed nominal bond alternatives, especially after adjusting for risk (no inflation or credit risk).
- Foreigners are not large players in this space.
- They provide valuable portfolio insurance in the seemingly unlikely scenario of a spell of elevated inflation or even the expectation thereof (a scenario that would be very challenging for traditional cash and fixed-rate nominal bond instruments).
- ILBs play a valuable role in the portfolio as they bring a significant all-weather dimension to multi-asset and fixed-income portfolios by having an adjustable base-rate mechanism. During periods of unexpected, elevated inflation, this provides an invaluable counterbalance to many exposures in a portfolio. In times when other floating alternatives are unattractive, short-dated inflation linkers can be an efficient instrument choice.
While short-dated ILBs are a compelling alternative to cash and floating-rate credit today, we also find significant opportunity in long-dated ILBs. These can be volatile given relatively high duration characteristics (price is more sensitive to changes in yield), but at sufficiently high starting real yields they can begin to compete against equity alternatives, at much lower levels of risk.
In the chart, we consider the expected range of outcomes for the FINI 15 equity index (a good proxy for SA interest rate-sensitive equities) and a long-dated ILB maturing in 2050 looking forward over a one-year horizon. We consider four scenarios. A bear case, in which we assume a return to the (record) low levels reached during March/April 2020; a status quo scenario, where there is no normalisation in rating; an upside scenario, where the rating reverts to the 10-year average; and finally, a bull scenario, where the 10-year 90th percentile rating levels are reached.
The two investments have similar starting dividend/coupon yields of 5% and 4.3% respectively. Assuming no change in rating and that capital grows in line with inflation (assumed at 5%), we arrive at similar status quo returns. However, considering the range of outcomes on the down- and upside, we see favourable asymmetry from the long-dated ILB — especially considering the risk-free nature of the investment.
The last year has seen a profound recalibration of the fixed-income opportunity set. We have responded by reducing our cash and credit exposures and adding to nominal and inflation-linked bonds, where short-dated linkers are playing a valuable cash-type role and longer-dated instruments are providing equity-like expected returns at substantially lower risk.
• Jooste is fund manager at PSG Asset Management.
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