Understanding the question

This is a question that is being asked by investors in the current challenging environment. It’s good question because it opens up a discussion that allows a deeper understanding of the investment objectives of flexible fixed income funds in general.

To be more precise about how the question is usually phrased, the logic behind it goes something like this:

”I invested in this fund because I thought it was risk-free, but now I am worried because I am seeing a negative return on my March investment statement, and I think I would prefer to get out of the investment and go into a money market fund to protect my capital; is this a good idea?”

The background

To say that this has been an extraordinary month would be a huge understatement. No one needs to be told that we are currently living through unprecedented and historic times. We also understand investors are reading their investment statements (and this document) while confined to their homes under a national lockdown.

As well as this being an extremely unusual time on a personal level, it is also very much extraordinary from a financial markets perspective. The economic shutdowns observed throughout the world will likely lead to one of the worst global economic contractions observed in our lifetime. The estimates of the impact on global economic growth are changing constantly, but the contractions we’ll witness this year will not have been seen since at least World War II. The prices in financial markets quickly adjust to reflect the future and thus were not left unaffected as this reality became clear. Pretty much every asset class in the world ended the first quarter of 2020 in sharply negative territory. Only ‘safe haven’ asset classes such as gold and the US dollar were spared, but even the price movements in these types of investments moved wildly and erratically throughout the first quarter, reflecting the extent of financial market stress felt in every corner of the globe.

In this environment investors tend to panic and look to move their investments into the safest places possible. Investment professionals call this “a flight to safety”. Because South Africa is an emerging market in the global context, our financial asset prices took a beating as international investors sold their investments to transfer them to perceived safe havens such as the US dollar. As a result, our currency weakened and moved above 18 to the US dollar towards the end of March (albeit also due to the strength of the US dollar as investors similarly removed their investments from other emerging market countries around the world).

Local listed property investments (REITs) and our local stock market (equities on the JSE) saw significant declines. In addition, our local government bonds were sold off to a degree which we have not seen in the last few decades.

What are the investment objectives of flexible fixed income funds and what types of underlying investments do they typically make?

The definition of what the Association for Savings and Investment South Africa (ASISA) calls multi-asset income funds (just different terminology for flexible fixed income funds) is as follows:

“These portfolios invest in a spectrum of equity, bond, money market, or real estate markets with the primary objective of maximising income. The underlying risk and return objectives of individual portfolios may vary as dictated by each portfolio’s mandate and stated investment objective and strategy. These portfolios can have a maximum effective equity exposure (including international equity) of up to 10% and a maximum effective property exposure (including international property) of up to 25% of the market value of the portfolio.”

More broadly, these types of funds can invest in a broad array of investment types which also include cash, government and corporate bonds, inflation-linked bonds, listed property (both in South Africa and internationally), preference shares,floating rate bonds and credit linked notes. While according to the ASISA definition these funds can hold equities, many do not and those that do, typically hold very small allocations in equities.

While flexible fixed income funds are managed in a conservative and defensive manner, it is important to note there are no explicit guarantees that they will always outperform cash over short periods of time. Capital losses are possible, especially in the case of negative credit events affecting underlying holdings.

In addition, an investment term of 12 months and longer is recommended because the fund’s exposure to growth assets like listed property and preference shares will cause price fluctuations from day to day. This makes it an unsuitable alternative to a money market fund over very short investment horizons (12 months and shorter).

It should also be noted that these types of funds are more likely to underperform money market funds in rising interest rate environments. In a rising interest rate environment fixed rate bonds will decline in value, and the degree to which they do so will be a function of their duration (or interest rate sensitivity).

Many flexible income funds typically have no or low equity exposure and derive most of their investment return from interest yields, and while generally providing more stable capital values than other investments (with the probability of capital losses over the shorter term unlikely), they provide no absolute guarantees. These portfolios typically target returns in the region of 1% – 3% above inflation before tax over the long term.

Now that we understand the various investments that flexible fixed income funds make, we can focus on those investments within these funds that experienced negative returns during the month of March and why this occurred. We will then go on to explain whether we believe this was because the investment portfolios were managed poorly or inappropriately, or whether this was to be expected in such an extraordinary environment, especially considering that these funds do not promise to be absolutely free of risk, particularly over periods shorter than 3 months.

Which investments were the main reasons my flexible fixed income funds experienced negative returns during the month of March?

To understand the investment performance of the various flexible fixed income funds during the month of March we need to understand two things:

1. The performance/investment return achieved by each investment type (asset class).
2. The amount invested in each asset class within each portfolio (the asset allocation).

So let’s first look at the return each type/category of fixed income investment delivered during March, ranked from best to worst performing in the table below (note: the STeFI Composite can be thought of as the return of cash).

As we can see, there was really nowhere to hide. With the exception of cash-type instruments, all fixed income investment types had negative returns. One exception would have been floating rate bonds, whose price is not affected by changes in interest rates. Instead, the yield on these types of investments adjusts dynamically as the market interest rates change. In other words, floating rate bonds have no duration.

Next let’s take a look at the asset allocation of three flexible fixed income funds:

Conclusions

For flexible income funds to provide the long-term returns expected of them, which are generally in the order of 1.5% to 2.5% in excess of cash, they need to invest in higher-yielding asset classes than cash-like instruments, like the ones listed above. Flexible fixed income managers create diversified portfolios of relatively conservative assets to generate the types of returns we expect from them.

However, they are not entirely free of risk – the only asset class that can provide that level of security is cash. The trouble with cash, however, is that it does not provide a high enough level of return to suffice for most investment objectives. The various flexible income funds have seen varying degrees of drawdown in the current volatile environment, depending on the proportion invested in each asset class, as well as the duration of the portfolios. Some funds had more property exposure, some had more inflation-linked bond exposure, and some others greater duration.

It is important to remember that global financial markets are currently experiencing unchartered turmoil, with virtually all asset classes selling down aggressively. Examples of the extent of this carnage can be seen in the table below, which shows the returns for some of the major asset classes for the period 1 January 2020 to 31 March 2020.

If one assumes no further declines in assets, one can expect flexible fixed income funds to yield a healthy margin of approximately 2% p.a. above Money Markets over the next two years. We selected a two-year projection timeframe as this is the average term (duration) of the assets in these types of funds. In addition, if the yield generating assets are held to maturity and these funds do not suffer any defaults, this is the approximate type of return that will be earned.

Due to the strict credit controls and vetting that the asset managers apply to these funds, we also do not foresee any permanent losses arising in these funds. We believe current performance is short term and that it will recover once sanity returns to investment markets.

It is also important to remember that in times of market turmoil, asset prices get marked down and this affects the valuation levels of flexible fixed income funds. However, market turmoil presents opportunities to acquire new assets at low prices and to enhance overall returns over time. Our strong recommendation to investors would therefore be to remain invested so that these returns can be given the time to come to fruition.

Please see the separate addendum that explores the concept of the yield curve and duration in further detail which may also assist in further understanding of flexible fixed income funds.