The impact of the Covid crisis has been a bit like a freeway collision in the asset management space. In an attempt to avoid disaster, most managers jumped on their brakes, panicked and tried to swerve into open spaces. Unfortunately, those caught in the wrong lane, or who were not paying attention or driving bad vehicles, simply crashed. The height of the mayhem took place in late March 2020, a couple of days into full lockdown. Away from their desks and isolated from their teams, investors were left scrambling to make the right decisions.
Although the market dynamics were distressing, we were decisive in repositioning portfolios on the basis of our robust investment framework, which was by then readily accessible from our remote locations. The investment process continued unhindered by the onerous restrictions of lockdown. As a result, the Northstar SCI* Income Fund enjoyed its strongest calendar year return of 9.33 %.
Cash is very unlikely to deliver real returns over the next while, whereas short-dated inflation-linked bonds are far more likely to deliver positive real returns.
Apart from the opportunities that present themselves during market crashes, the dynamics of the interest rate cycle also impact fixed income asset pricing, which provides the opportunity for active managers to reposition portfolios favourably for outperformance. Conversely, more static portfolios can lag as they remain trapped in unfavourable assets that are not suited for certain phases of the interest rate cycle. This is a danger for low-risk investors whose investment horizons may be substantially shorter than the prevailing interest rate cycle, and therefore don’t get an opportunity to be exposed to more favourable asset classes.
To overcome this shortfall, we ensure a flexible approach to allocating capital to asset classes that stand to perform the best during any given phase in the interest rate cycle (see chart on historic asset allocations below). For instance, cash is very unlikely to deliver real returns over the next while, whereas short-dated inflation-linked bonds are far more likely to deliver positive real returns. Therefore, investors currently stuck in cash instruments are likely to endure negative real returns for the foreseeable future.
3 Year asset allocation history
With this backdrop in mind, the Northstar SCI Income Fund has healthy positions in inflation-linked bonds, an increased amount of fixed bonds as yields have risen and a low exposure to cash and floating rate notes. In addition, yield has been enhanced through exposure to senior bank paper specifically in inflation-linked bonds and shorter-dated fixed bonds.
Although similar yields can be accessed through subordinated additional tier 1 floating rate notes, investors must acknowledge they are trading two to three notches down the credit quality spectrum, which is the risky play. There is a perception that these instruments are low risk because of the lower volatility returns. It is true that the banks are well capitalised, however loan quality and profitability have been negatively impacted and in the absence of sustained demand for this paper, credit spreads would widen, resulting in permanent capital loss for short-term investors needing to redeem capital for income purposes. We are exercising great caution around these instruments as their reference yield, 3m JIBAR, is set to fall below the inflation rate.
In addition to the mix of high-yielding bonds held in the portfolio, which will do very well in a low interest rate environment, the portfolio has a healthy exposure to a range of global currencies including euros, Yen, pounds and US dollars.
These holdings are likely to maintain their value during any potential risk off events as capital takes flight to safety. Although putting on a brave front, the central bank is in a tight spot having to finetune monetary policy in response to a dislocation in the economy. In the absence of extreme inflation, interest rates are unlikely to return to their lofty real yield highs, and as a result, the rand is likely to remain challenged and trade with ongoing and heightened volatility. The offshore currencies provide an attractive counterbalance to the potential negative pricing of local bonds, during periods of distress.
In summary, we believe the Northstar SCI Income Fund is well-positioned for the prevailing economic dynamics, considering valuations, the future path of interest rates, inflation and sovereign risk. We are however cognisant that market conditions are constantly changing, and we remain alert to making the necessary and appropriate asset allocation adjustments as per our risk and valuation framework.
*SCI refers to Sanlam Collective Investments