The Distorted State of South Africa’s Credit Markets

And how it influences our portfolio positioning.

In all investment activity, one must take some risk to generate returns sustainably exceeding the risk-free rate. In fixed-income, for example, portfolio managers are constantly faced with the choice of how to balance and optimise credit risks, inflation risks, liquidity risks and duration* risks to produce alpha for clients. Some of these risks are easier to measure than others. While duration risks manifest through direct price volatility, credit, inflation and liquidity risks bubble underneath the surface of what’s visible to the end clients (or even, in some cases, the portfolio managers themselves).

It is unsurprising in this context that many fixed-income fund managers, frequently under pressure from clients and peer-group surveys, tend to shy away from the more visible risks that duration-heavy strategies entail. In the ASISA (Association for Savings and Investment South Africa) category of South African multi-asset income funds, it is not uncommon for portfolio managers to self-impose an upper limit for a weighted average duration of 2.0, with many funds positioned for a significantly lower duration than this. According to the most recently available minimum disclosure documents, the median duration of South Africa’s largest multi-asset income funds is just 1.4.

However, self-imposed investment limits naturally constrain what a portfolio manager can achieve long-term. For instance, where high-duration instruments may be undervalued, a portfolio with self-imposed duration limits will not be able to exploit the opportunities available to it fully. To generate excess returns, a constrained portfolio manager could then be pushed into other sectors of the market, such as lower quality, less liquid and high-yielding (but low duration) credit.

In the South African market, these dynamics are creating distortions in the valuation of the listed credit sector. Between bond funds and multi-asset income funds, the value of collective investment scheme assets under management is almost R500 billion. Accounting for short-term income funds and the estimated income allocation of the balanced fund universe may add another c.R600 billion to this figure. Most of this money searches for a home in the local listed fixed-income market. By comparison, the non-bank corporate credit sector, at c.R180 billion outstanding, pales in size (and we have not yet accounted for segregated institutional mandates).

It is little wonder than that structurally riskier credit instruments, such as AT1 (Additional Tier 1) subordinated bank notes, have been bid up from a yield spread of 7% in 2015 to just 3% today. In fact, the South African AT1 market is significantly more expensive than its global counterparts, where yield spreads are as much as 100 bps higher. The convergence of too much money chasing few assets forces competitive fund managers to reach up the credit risk curve, chasing higher yields from lower-quality borrowers. Recent financial distress in the South African mini-bus taxi industry, a significant sector of the local credit market, serves as a dramatic reminder of the type of risks prevalent in ‘high-yield’ credit strategies.

Instead of competing in the overcrowded credit market, the Merchant West SCI* Enhanced Income Fund is thus positioned to exploit undervalued, but longer duration instruments in the local bond market. We do not impose a constraining duration limit on the Fund but rather position the portfolio to achieve an optimal sustainable return profile. As a result, our Fund had a weighted average duration of 3.0 at the time of writing (See also: Carefully picking our poison). This positioning has allowed us to exploit the unsustainable combination of high real yields and high inflation premia being applied to the local government bond market, particularly at the long end of the yield curve.

It also means that our Fund can benefit from capital gains if real yields decline to a more sustainable level. More precisely, a one percentage point decline in interest rates will typically result in an approximately 3.0% gain in the capital value of the Fund (it would be slightly more than this due to an underappreciated feature of the fixed-income universe: convexity). Of course, interest rates may increase as well, resulting in a capital loss commensurate with the duration of the Fund. However, in the case of a one percentage point rate increase, a Fund with a duration of 3.0 would typically produce a capital loss of slightly less than 3.0% (again: convexity).

Sometimes, this level of price volatility can be incorrectly perceived as excess risk relative to peers. However, we believe that it is simply, a different, perhaps even more sustainable risk exposure (better the devil you know?). When viewed this way, traditional measures of ‘risk-adjusted’ returns, which only consider price volatility risk, are clearly inappropriate despite underpinning most investment industry accolades.

Furthermore, we have shown that where clients have a large global equity exposure (a scenario increasingly common amongst South African savers), the type of volatility exhibited by the local bond market can actually reduce the volatility of one’s overall wealth (See: When more risk is less risky). This is the essence of modern portfolio theory in action.

As 2023 saw an increase in global bond yields and a similar increase in the level of South African interest rates, we were disappointed, but not surprised, that the Merchant West SCI* Enhanced Income Fund had a year of relative underperformance in its peer-group category. However, as real yields normalise to a more sustainable level, our portfolio is optimally positioned for sustainable alpha generation in future.

*For brevity, we use ‘duration’ to refer to modified duration: the sensitivity of an asset’s price to changes in interest rates.

* Merchant West Sanlam Collective Investments Enhanced Income Fund

By Daniel King , Portfolio Manager and Head of Fixed Income Merchant West Investments

Disclaimer: Sanlam Collective Investments (RF) (Pty) Ltd is a registered Manager in terms of the Collective Investment Schemes in Securities. Collective investment schemes are generally medium to long-term investments. Please note that past performance is not necessarily a guide to future performance and that the value of investments may go down as well as up. A schedule of fees, charges and maximum commissions can be obtained from the Manager. Additional information of the proposed investment, including brochures, application forms and annual or quarterly reports, can be obtained from the Manager, free of charge. Collective investments are traded at ruling prices and can engage in borrowing and script lending. The Manager does not provide any guarantee either with respect to the capital or the return of a portfolio. Charges of the most expensive fee class, maximum fund charges include (incl. VAT): Manager initial fee (max.): 3.45%; Manager annual fee (max.): 0.63%; Total Expense Ratio (TER): 0.66%. The Manager retains full legal responsibility of the third-party portfolio. The registered name of the Fund is “Merchant West Sanlam Collective Investments Enhanced Income Fund.” The performance of the portfolio depends on the underlying assets and variable market factors. Performance is based on NAV-to-NAV calculations with income reinvestments done on the ex-dividend date. Lump sum investment performances are quoted. Collective investments are calculated on a net asset value basis, which is the total market value of all assets in the portfolio including any income accruals and less any deductible expenses such as audit fees, brokerage, and service fees. The actual investment performance of the portfolio and the investor will differ depending on the initial fees applicable, the actual investment date, and the date of reinvestment of income as well as dividend withholding tax. Past performance is not indicative of future performance. The Management of this portfolio is outsourced to Merchant West Investments (Pty) Ltd, (FSP) License No. 44508, an Authorised Financial Service Provider under the Financial Advisory and Intermediary Services Act, 2002.