South African investors need to free their minds of the idea that they can take very little risk – even just invest in cash – and still earn inflation-beating returns, investment managers are warning.
Three managers who spoke at the recent Momentum Independent Multi-Manager Conference warn that fixed-interest returns will be lower, and investors who require higher returns will have to take more risk by investing in longer-dated bonds, corporate bonds, listed property or equities.
Their message is aimed in particular at investors who rely on their investments for an income and who are invested conservatively, often largely in cash.
David Knee, head of fixed income at Prudential Portfolio Managers, says the real (after-inflation) return from cash investments in South Africa is currently close to zero, which should come as no surprise given that it is minus two in the United States.
Inflation, as measured by the consumer price index (CPI), reached 6.1 percent for the year to April, while money market funds are yielding between 5.8 percent and 5.2 percent a year. This means that in the year ahead a money market fund investment will lose against inflation, especially if you pay tax on the interest.
It is no time to be sitting in cash, Conrad Wood, head of fixed income at Momentum Asset Managers, says. However, he warns that you should also temper your expectations for returns from other fixed-interest instruments, because they have performed exceptionally well over the past few years and there are plenty of risks at present.
Jonathan Myerson, head of fixed interest at Cadiz Asset Management, says that over the past 20 years we have been spoilt by the ease with which we could earn real returns, but the next 20 years are unlikely to be like the past 20.
Knee says an investment that targets inflation plus three percent has in the past been able to deliver this return by investing largely in money market funds, but in future it will be a challenge to achieve this target without broadening your portfolio’s universe to include equities and/or listed property.
Wood says South African bonds have been supported by huge investments from foreign investors looking for higher yields than are on offer in developed markets. This has drawn out the usual interest rate cycle and prolonged the out-performance of these and other fixed-income assets, he says.
However, Wood says, the local bond market could experience periods of volatility when globally investors become particularly risk averse and disinvest.
He also warns that, although this could still be some way off, your capital in bonds could be at risk when interest rates start to rise in the developed world, luring foreign investors out of our markets.
Don’t expect inflation to ease off in the near future either, the managers warn.
Inflation can help governments to reduce their real debt levels, and they will maintain low interest rates for longer than they should, creating higher inflation.
In addition, South African monetary authorities have a broader mandate of using monetary policy to target growth and employment if, in their opinion, inflation is under control, Wood says.
South Africa’s interest rates are at record 30-year lows.
Although we should be nearing a period of interest rate hikes given that inflation is above the target band, the normal cycle has been derailed by the flood of money into emerging markets and the higher than normal tolerance for inflation in these markets, Wood says.
Myerson says inflation is likely to remain close to the upper end of the inflation target for some time, and the Reserve Bank, with a focus on enabling growth, could keep the repo rate at or close to historical lows for some time – probably until the second half of next year.
You need to hold a diversified portfolio of fixed-interest assets to optimise your income in a low-interest environment, Myerson says.
The fixed-interest assets in these portfolios include inflation-linked bonds, corporate bonds, floating rate notes, listed property and offshore fixed-interest assets.
Inflation-linked bonds pay an interest rate linked to inflation but can be volatile and tend to perform better when inflation is rising.
Coronation, which has also been encouraging its investors to choose funds that diversify across the fixed- interest universe as alternatives to cash, has reduced its exposure to inflation-linked bonds, particularly government bonds, from 20 percent to 13 percent in its Strategic Income Fund, because these bonds have had such a strong rally.
Coronation’s head of fixed interest, Mark le Roux, says Coronation bought these bonds in 2009, when inflation was at three percent. Now that inflation is at six percent and is likely to stay there, the manager believes it can do better by investing in corporate bonds.
Wood says there is currently a big enough gap between the yield on local inflation-linked bonds and Treasury Inflation-protected Securities in the United States, so foreign investors are likely to continue to invest in local bonds. This will support the price at which these bonds trade. Like any other asset class, they will be prone to volatility in this uncertain environment.
Floating rate notes have a variable interest rate that rises and falls in line with money market interest rates. On average, Coronation says, these instruments offer a yield of one percentage point over money market rates and are good to hold when interest rates are rising.
Corporate bonds typically pay 1.25 percentage points higher than the yield on a government bond of similar duration (period to maturity), as they are regarded as having a higher credit risk, Wood says.
Listed property can also be used to enhance the return of an income-earning portfolio (see “Good reasons to add listed property to your investment mix”, below).
Although government bonds in many foreign markets may currently be investments to avoid, some fund managers are using corporate bonds in foreign markets to earn additional returns for you.
GOOD REASONS TO ADD LISTED PROPERTY TO YOUR INVESTMENT MIX
With managers of fixed-interest funds struggling to deliver good yields, it will be difficult to ignore the benefits of investing in listed property, managers of real estate funds say.
Ndabezinhle Mkhize, a property analyst at Stanlib, says South African listed property is a very positive and much misunderstood asset class.
With a market capitalisation of R160 billion (the value of all property shares), ignoring the listed property sector is like ignoring something as big as the hospital and pharmaceutical sector, Mkhize says.
He says many fund managers are shying away from property, saying it has run too hard and is unlikely to continue to deliver. However, Mkhize says, the valuations of the local listed property market are cheap relative to bonds and are fair relative to equities, because listed property returns have been driven by these shares’ steadily growing income rather than by a re-rating of the share prices.
It has been four-and-a-half years since listed property prices peaked in November 2007 to the end of April this year, Mkhize says. Over this period, listed property, as measured by the FTSE/JSE SA Listed Property index, delivered a total return of 61.6 percent. Of this return, 50 percent has been a result of the growing income produced by these shares and 11.6 percent as a result of increases in the share prices.
Ian Anderson, chief investment officer at Grindrod Asset Management who manages the Nedgroup Investments Property Fund, says listed property is significantly undervalued, because investors are underestimating future income growth.
There has been a super-cycle in listed property, Anderson says. It has returned an average of 26.7 percent a year over the 10 years from April 2003 to March this year – about 20 percent more than inflation for the period.
The property super-cycle was driven by steadily declining interest rates and high real income growth, Anderson says.
Although the super-cycle may not continue, Anderson is of the view that property will in future return the consumer price index (CPI) plus seven to nine percent.
South African listed property is unique, Anderson says, in that rentals escalate above inflation and this, together with the financial gearing (borrowing to invest) and operating efficiencies in listed property companies, provides investors with an inflation-hedged income stream.
However, Marriette Warner, manager of Absa’s Property Equity Fund, says you must have a long-term view if you invest in listed property now.
Property is fairly priced, but if bond yields fall, this will be negative for listed property because property tends to follow long bond yields, she says.
Rising income from listed property should mitigate the fall in listed property prices, Warner says.
A yield that grows over time is better than investing in cash when interest rates are below inflation, she says.
Investors who depend on their investments for an income should understand the capital volatility that comes with investing in property, Warner says.
Mkhize says the growth in listed property companies’ income streams has never been negative. And in only three of the past 17 years have South African listed property investors experienced capital losses as a result of share prices falling, he says.
Anderson says it is difficult to predict the income you will earn from a share, but it is much easier to predict the income you will earn from listed property, and for this reason investors should be prepared to pay more for listed property than for equities.
Mkhize says listed property should be compared to bonds rather than equities, and Anderson says you should not forget that property has good diversification benefits when it is combined with equities.
INVESTING IN A DIVERSIFIED FIXED-INTEREST PORTFOLIO
There is a wide range of unit trust funds that invest in an array of fixed-interest instruments and other income-earning assets, such as listed property.
These funds are in the domestic fixed-interest varied specialist sub-category, and there are some in the domestic asset allocation prudential low equity and the targeted absolute and real return sub-categories.
Before you invest, you need to understand how these funds invest. For example, some funds invest only in bonds and money market instruments, while some include these instruments and listed property. A few funds, focused on investors who require an income, also have low exposures to high-dividend-earning equities – and these funds are typically in the two asset allocation sub-categories.
Some fixed-interest varied specialist funds invest in certain assets only – for example, only in inflation-linked bonds or in corporate bonds.
Among the funds that invest across the range of fixed-interest instruments, the Cadiz Absolute Yield Fund has returned 10.18 percent a year over five years and 9.43 percent a year over three years to the end of March (according to ProfileData).
The Coronation Strategic Income Fund has returned 9.21 percent a year over the past five years and 10.33 percent a year over three years.
The Momentum Diversified Yield Fund has returned 9.16 percent a year over five years, and 8.43 percent a year over three years. The Nedgroup Investments Flexible Income Fund (A) has returned 9.57 percent a year over five years and 8.05 percent a year over the past three years.
In the asset allocation prudential low equity sub-category, Old Mutual’s Real Income Fund limits its exposure to listed property and equities to 35 percent. Despite this low exposure to riskier assets, it has achieved a five-year return of 9.07 percent a year and 11.57 percent a year over three years to the end of March.