The fate of income fund returns

By: Jean-Pierre Matthews CFP, CFA, Head of Product, Matrix Fund Managers

Jean-Pierre Matthews

During the Covid years, most central banks initiated extensive, synchronised monetary stimulus. Global interest rates were slashed, and many central banks engaged in quantitative easing to flood global markets with cheap money to increase disposable income and fuel economic recovery.

But this was ultimately inflationary and, combined with disrupted global logistics and the Russia-Ukraine conflict, prices soared. To combat high inflation, a policy rate hiking cycle commenced in early 2022. We are now probably at the top of this cycle as global inflation is tamed and fears turn instead to economic recession.

With the world’s attention focused on the US Federal Reserve, and expectations of imminent US rate cuts, the rest of the globe is expected to follow suit. Investors have been spoilt with high yields over the last few years, and income funds have performed very well relative to other categories. But will these funds remain a good option for investment?

Massive flows into fixed income funds

In the SA unit trust industry, the AUM of fixed income funds (excluding money market funds) surged from R250bn at end-2015 to around R820bn at end-2023, reaching 33% of total SA industry assets (excluding money market funds).

What’s driving this growth?

While the rate hiking cycle contributed to the flow into interest-bearing assets, a crucial factor has been the steady decline in South Africa’s global sovereign credit rating, resulting in higher yields.

Figure 2 shows how the 10-year SA sovereign USD debt credit spread (red line) has fluctuated and deteriorated over the past decade. First it tracked the A-rated sovereign spread (e.g. China) and then the BBB-rating spread (e.g. Mexico) and then it leapt to the BB-rating spread (e.g. Brazil).

What the graph also shows is that the SA credit spread anticipated each looming rating downgrade, moving well ahead of official announcements. While SA is currently rated BB, our spread is edging towards a B-rating (e.g. Turkey), indicating that international markets are concerned about a further sovereign credit downgrade. At present, SA needs to pay around 3.5 percentage points (%pt) per annum more for 10-year equivalent debt than AAA-rated sovereigns and about 1%pt more than the average BB-rated sovereign.

Bad news can be good news…

The bad news is that SA is a high-yield country. The SA government, and therefore most SA borrowers, need to pay more in interest payments. The South African Reserve Bank (SARB) has also had to keep policy rates higher to attract capital, support the rand and maintain price stability – and the cost of debt has increased across the yield curve.

However, if you are a net saver, the good news is that we are a high-yield country! You will be earning more interest now than you would have before our sovereign downgrades – all else being equal. In fact, you can now earn an unprecedented high real yield by investing in a regular fixed deposit. One-year fixed deposits currently yield 9% per annum – that is more than 3% above expected inflation. Who says you can’t beat inflation by investing in the money market?

What about rate cuts?

With inflation fears subsiding and recessionary fears brewing, markets are widely expecting interest rate cuts. In the US, inflation peaked at 9.1% in mid-2022, and retreated to 3.2% in February 2024. The US Fed Funds policy rate was steadily raised from 0% to 5.5% as inflation surged, and is now expected to be cut by some 100 basis points over the next year.

In SA, inflation peaked at 7.8% in mid-2022, falling to 5.6% in February this year. The SARB also steadily raised its repo rate from an unprecedented low of 3.5% in 2021 to 8.25% in May last year. SA market participants expect the SARB to start cutting the repo rate later this year.

At Matrix Fund Managers, we agree that global policy rates should decline, but we believe that the timing of SA monetary policy accommodation will lag that of the US and developed markets by more than the market expects – possibly only seeing rate cuts late in 2024 or early in 2025.

With the US real policy rate currently at historic highs – around 3%pt (300 basis points) above expected inflation – it’s at a similar level to SA’s real policy rate and is placing pressure on the rand.

We expect the SARB to start cutting the repo rate once SA inflation settles around the midpoint of the target range (4.5%) and the US real policy rate is around 1-2%pt lower than the SA real policy rate. We also foresee the SARB maintaining its real policy rate around 2-3%pt above expected inflation.

Outlook for income funds

We believe that fixed income yields will continue to offer good value to investors – especially income funds. Our base case scenario sees money market deposit rates down by around 0.75%pt over the forecast period, with most of the move occurring only in 2025. Furthermore, rates should only move lower when inflation settles at lower levels. This means that the real yield earned on income fund investments is likely to remain at elevated levels over the coming year.

In short, deposit rates may start falling later this year, but real yields offered by income funds should remain as compelling as they were in 2023 (around 3% above inflation).

Moreover, with these high real yields on offer by the SA government and major banks, it should not be necessary to invest in less-liquid, higher-risk corporate and securitisation debt to achieve inflation-beating income fund returns.

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