Low interest rates and how to solve for them
By Adam Bulkin, head of Manager Research at Sanlam Investments Multi-Manager
Over the last one, three and five years, cash and bonds produced fairly similar, inflation-beating returns, while growth assets (equities and property), produced volatile, very low to negative returns that deeply underperformed inflation. Below is a table, as at 30 September 2020, of the annualised returns of these major asset classes:
Over that same period, short-term loans to banks and other companies (termed credit) increased in value, as the price that investors were willing to pay for this credit increased, and those holding the loans or credit benefited from these increasing prices. Technically, this is referred to as the credit spread decreasing, or tightening. When credit spreads tighten, credit increases in value. When spreads widen, credit decreases in value.
As a result, over the last few years, income unit trusts, and particularly those that were holding credit, generated returns well above cash. Income unit trusts tend to hold these short-term loans or credit.
Investors have found refuge in income unit trusts
With the memory of the COVID-19-induced stock market crash of the first quarter of 2020 fresh in people’s minds, it is no wonder that investors have lost faith in equities and property. For taking on the extra volatility and risk of these growth assets, sadly investors have been punished with lower returns, rather than being rewarded. These investors have flocked to cash and income unit trusts, which have produced far higher returns at far less volatility over the last five years.
But going forward, income funds will battle to give more than 6% before tax
However, just as this has happened, we have now experienced short-term interest rates dropping to historically low levels, not seen in many decades. Going forward, those investors that have placed their money in the bank will be receiving less than 4% gross of tax and well under 3% net of tax.
Income unit trusts will, in the coming months, fare not much better. Most of the credit they hold is priced off the current interest rate. In addition, the extra return these income unit trusts earned over the last few years as credit spreads tightened will almost certainly not be a feature of future returns. While it is not necessarily so that credit spreads will widen, even in this tough economic climate, it is extremely unlikely that they will narrow further from these levels.
What this means is that the return from income unit trusts is likely to be about 5-6%, before tax, for at least the period that interest rates stay at these low levels.
Investors will start to realise that their net of tax return of about 2-4% from cash and income unit trusts is not going to beat inflation, even if inflation is at the lower end of the Reserve Bank’s inflation targeting range.
Three ways fund managers will attempt to solve the low-return problem
What is the likely outcome and what can investors do? We think that there are several likely scenarios that will play out over the coming months. The first is that some income fund managers will adjust their portfolios to achieve higher returns. How will they do this?
- Firstly, they may increase their allocations to property, which is generating a very high yield because the property stocks have decreased in value so significantly. As noted above, these stocks have lost in excess of 45% of their value over the last year.
- Another way would be to invest in lower quality credit, which pays a higher yield because it is riskier.
- Finally, they may invest in longer duration government bonds, which are paying a much higher rate, but, as we discussed above, also come with more risk and sensitivity to interest rate moves.
The problem with all these strategies is that, while they will increase the potential return for the investor, they will also increase the risk for the investor – the volatility. And for investors who rely on these unit trusts for income, increased volatility is not just a theoretical risk but a very real one. This is because when you are drawing income from your retirement savings, if the capital value of the savings decreases due to volatile asset prices, you still draw the same rand amount of income. This means that your savings decrease more quickly than planned, as you draw the same rand amount from a lower capital amount. Even if the asset value increases in future, due to the same volatility, the damage would have been done. Volatility of asset prices is the enemy of a retiree who is steadily drawing income from that pool of assets.
Faced with this dilemma, is investing in lower quality credit, property or bonds a sensible investment, even if they come with higher volatility?
1.Over the short term property may continue its volatility
Over the medium to long term, we think that property is likely to produce high returns, as these property companies begin to generate returns from rentals as the economy recovers after the COVID-19 crisis, and there is more certain information about the revenue of these companies. We think that the bad news about property companies is mostly reflected in the current prices, and that even small improvements my lead to increases in the stock prices. However, over the short term, property stock prices may well continue to experience heightened volatility and be highly reactive to any further deterioration in the economy.
2.Low quality credit is not the solution
We think that investing in lower quality credit is not a sensible thing to do. Credit is, at the best of times, very difficult to trade out of or sell, or illiquid. When credit is lower quality, i.e. more risky, then this illiquidity increases. In the current economic environment, where the outlook is not clear and there is so much disruption, we think the risk that one takes in buying such lower quality credit does not make up for the potential return one may get.
3.Longer duration bonds deserve some consideration
The essential difference between bonds and shorter-term loans is that the term of a bond is longer. The longer the term of a bond, the longer its duration. Duration is vital because it changes the way a bond will react to an increase or decrease in the yield of a new bond of a similar duration. Think of it this way. If I lend you money for 10 years at 8% interest, the term of the bond is 10 years. Now, if for some reason, the going rate of interest in the market increases to 9%, then my bond with you is worth relatively less, since I now could lend you money at 9%, and so I am stuck with a bond which is giving me a lower rate of interest, or yield, than I could get now.
In other words, the price or value of the bond decreases when the going rate goes up, and the price increases when the going rate goes down. In fact, for a bond with a duration of 10 years, for every 1% increase in the going rate, or yield, the bond’s price will decrease by 10%!
Furthermore, the longer the term, the longer I am tied into my original rate, which means if the going rate goes up and the duration of my bond is 20 years, for example, its value will decrease more than if the duration of my bond was 10 years, since I will be earning less interest for longer.
Why is this important? Because the longer the duration, the more sensitive it is to changes in rates, and therefore the more volatile is its price.
However, the 10-year South African government bond (SAGB) is generating a very high yield of 9.5% (as at 30 September 2020), which is one of the highest in the world. The chart below, courtesy of Prescient Investment Managers, shows the yield of these bonds in relation to other emerging market bonds. It also shows why our bonds are at such high yields, and this is because investors want to be compensated for the extra risk (the risk premium or excess yield) that they take to invest in SAGBs, instead of investing in US bonds.
There are two risk premia. The first risk premium is the sovereign risk premium, which is the risk that South Africa cannot or will not repay the bond – in other words that South Africa defaults on its debt. The second is the currency risk premium, which is the risk that, when the bond is repaid, the currency would have weakened to a great extent, thereby rendering the asset worth a great deal less.
We can see that investors require a currency risk premium of 5% and a sovereign risk premium of 3.8% to invest in SAGBs, lower only than those of Turkey. Why are our risk premia so high? We know that government debt has been increasing at an alarming rate. As outlined by National Treasury itself, if we do not control our expenses, improve growth and confront seemingly intractable problems, such as ever-increasing government wages, failed SOEs and corruption, government’s debt-to-GDP ratios will quickly rise to unsustainable levels in terms of which our debt will be well above our annual income. The graph below shows the trajectory of the debt-to-GDP ratios if we continue on our current path (the “passive” scenario) and if we work to solve these problems and bring our debt under control (the “active” scenario).
The risk premia we referred to above demonstrate that investors are worried that these problems will continue to manifest, and that they will not be effectively or well controlled.
Some investors argue that SAGBs have very high inflation-adjusted yields and should therefore attract more buyers than other emerging market bonds. We do not think that this argument is well-founded. Global and local investors are aware of our economic problems and all the other fundamental factors affecting our bonds, as well as those of other countries. They have assessed the risk of our bonds in accordance with this awareness. Therefore, unless the fundamentals are better than expected, which is possible but not certain, the yield is appropriate for the risk, and our risk-adjusted yield is not higher than those of other bonds.
A final aspect to consider is the question of default and currency risk. In general, governments are extremely reluctant to default on debt. It makes raising debt in future very difficult and is a matter of national embarrassment. We do not think that our government would readily default on its debt. However, there are other actions it might take to try to solve our problems. The great majority of SAGBs are issued in rands. This is significant because, in a very bad scenario in which we face a debt death-spiral as our debt increase exponentially and our income decreases steeply, the government could literally print more currency to pay bond holders the rands that it owes. A version of this scenario occurred in Zimbabwe. This would not be easy, but it is possible. It would mean the Reserve Bank would have lost independence and would mean economic ruin, but technically investors would still be repaid.
Another, far less extreme scenario, would be one such as government regulating the purchase of prescribed assets, in terms of which savings pools, such as pension funds, would be required to invest in particular issues of SAGBs to promote growth through the use of the monies raised to invest in infrastructure or other capital investments. Such a scenario would not necessarily be disastrous, if it leads to effective capital investment without inefficiency and corruption. However, the capacity of government to manage such projects optimally has been put into question. It may also lead to negative sentiment, domestically and globally, which would probably weigh on our currency, growth and bond yields, thereby having the opposite effect to its intention.
Several ways for us as multi-manager to play a role in this low-return environment
There are a number of ways we think we can help clients. The first and most immediate one is to research and understand how income fund managers are reacting to the environment and what risks they are taking, so that we can manage our clients’ risks appropriately.
We think that fund managers that are able to change the duration of their income unit trust in a flexible and dynamic manner will have an advantage in an environment where credit is not able to be a strong driver of returns, but bonds are providing high yields. We are considering fund managers that have demonstrated the ability to invest in bonds and take advantage of the extra return from duration, but at the same time have adjusted this duration in line with increasing and decreasing market dynamics in a flexible and nimble manner.
We are more cautious about managers that rely solely on credit to drive returns, particularly when it is low quality credit. We think that in this environment, the ability of the fund manager to analyze credit risk and act conservatively and responsibly is very important.
Another way we would like to assist clients is by being forward-looking and rational in asset allocation decisions. Decisions based on unknowable future events are neither easy nor certain, but we have high conviction that if we invest based only on the last five years’ history, we will be doing a disservice to our clients. We think that those assets that have performed so poorly in the past – the growth assets of equity and property – have better medium- to long-term prospects precisely because of this history. We have not thrown caution to the wind. We remain conservative. However, we are firmly of the opinion that a disciplined approach to long term investing requires a judicious but reasonable allocation to growth assets.
Finally, the solutions we are providing to clients are innovative and industry-leading. In our living annuity products, for example, we are embracing strategies like smoothed bonus funds, which allow us to gain exposure to growth assets but control for volatility. We are investing in hedge funds, private equity and private debt to enhance returns and manage risk. We are exploring global alternatives. We are making use of highly-developed quantitative tools to construct portfolios of assets which should generate returns and control for risk in a unique way.
While we are living through difficult and turbulent times, we are working hard to manage the present risks and opportunities for a better future.