INCOME FUND VOLATILITY

Increased volatility to be expected in the Enhanced Income Fund. The Counterpoint SCI Enhanced Income Fund has prided itself on delivering a competitive return to clients on a risk-adjusted basis since its inception.

Dear Client

The Counterpoint SCI Enhanced Income fund has prided itself on delivering a competitive return to clients on a risk – adjusted basis since its inception. The fund has been run as a low volatility income fund for most of its existence [see chart of fund 3y risk-return vs. the income funds major competitors].

The fund has found solid support in the market with this strategy, which rewarded the fund with steady inflows, acceler- ating over the past few years to breach the R1,1 billion mark two days ago. We thank you for your unwavering support; rest assured that we continue to focus hard on the fund in these trying times.

Over the past year or so, the fixed interest landscape in South Africa has materially changed.  Perhaps most important from the perspective of income funds, is that the SARB’s repo rate has been cut by 25 b.p. twice over that time.  This means that, all things being equal, the running yield of money market and income funds has dropped by roughly 50 b.p. over this period.   Income funds, including the CPAM income fund, did well notwithstanding, as their large holding of floating rate notes continued to price upwards despite the lower repo rate owing to compressing credit spreads.

Over the past few weeks, global markets have been repricing aggressively as they factor in the spreading risks of the COVID-19 virus.  Global interest rates have been cut over the past week to combat the effects of the virus, especially in the developed world.  With hardly any inflation pressures and an economy in dire straits, the SARB is expected to follow suit with at least another 25 b.p. cut next week (announcement due on the 19th March 2020), if not an outright cut of 50b.p. given the gravity of the situation. This will further reduce the running yields of income funds over the current investment cycle. With the credit spread compression dynamic seemingly troughing now, the approach to managing income funds has had to change. Passive yield harvesting is no longer as attractive a strategy as it was.

We have been saying in our various communications to clients that we would be increasing our exposure to the bond market once we thought it would be showing more value, which, given the recent sell-off, it now is. We have thus been incrementally increasing our exposure to this asset class, especially to the five-year area of the curve in the form of liquid R186 government bonds. At present, we consider this to be the sweet spot of the yield curve for our income fund, with balanced funds taking on higher duration risk. Other asset classes to which we have a low exposure, such as inflation – linked bonds, real estate and preference shares have also been selling off in the current COVID -19 induced risk-off envi- ronment and are now starting to reflect better value.

The difference between the yield on the R186 (trading at 8.6% now and well above the running yield of the income fund at 7.98%) and the 3-month NCD is 2.26%, the highest it has been in almost six years (barring the Nenegate episode). We are availing ourselves of this opportunity as we believe the yield enhancement to be worth the heightened volatility. We are also increasing exposure to securities which, on a conservative view, will give us dividends well above our required rate of return, at the risk of seeing their price dip over the shorter-term horizon.

The cost of this strategy, as we have said, is increased volatility in the fund. Note that this is not a change of manage- ment style or approach to running the fund; it is an attempt to uphold the yield of the fund given the opportunities we see. It will also necessitate more trading than usual in a fund which has had a low turnover rate.

Volatility is bound to be with us for a while yet. Moody’s South Africa rating review, due on the 27th of this month, is bound to shake-up the market if they downgrade the country to sub-investment grade, despite the downgrade already being partially priced into the bonds.

Our focus is firmly on this fund, as it is on all our funds in these topsy-turvy markets.

Our experience with past turbulent episodes of this nature is that markets eventually revert to normality, with the period of heightened volatility providing an opportunity to significantly improve the return prospects of the fund. Note that in this time of global financial market turmoil, the fund’s compelling risk-return profile continues to provide diversification benefits and a relative volatility haven as the sell-off in risk assets continues.

We remain at your disposal for any query you might have, and are ready to have any discussion or, even better, a confer- ence call on the evolving market conditions and the positioning of our funds.

Many thanks

Alex Pestana

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