Another good year in sight for returns from income funds

• Real yields should remain as compelling as they were in 2023 at about 3% higher than inflation rate

During the Covid-19 years, most central banks initiated extensive, synchronised monetary stimulus. Global interest rates were slashed, and many central banks engaged in quantitative easing, flooding global markets with cheap money to increase disposable income and fuel recovery.

But this was ultimately inflationary and, combined with disrupted global logistics and the Russia-Ukraine war, 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 global attention focused on the US Federal Reserve and expectations of imminent US rate cuts, the rest of the world is expected to follow suit. Investors have been spoilt by high yields in the past few years, and income funds performed well relative to other categories. But will these funds remain a good option for investment?

Enormous flows into fixed income funds

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

While the rate-hiking cycle contributed to the flow into interest-bearing assets, a crucial factor has been the steady decline in SA’s global sovereign credit rating, resulting in higher yields. The accompanying graph shows how the 10-year SA sovereign dollar debt credit spread (red line) fluctuated and deteriorated over the past decade. First it tracked the Arated sovereign spread (for example, China) and then the BBB-rating spread (Mexico), and then it leapt to the BB-rating spread (Brazil).

What the graph also shows is that SA’s credit spread anticipated each looming rating downgrade, moving well ahead of official announcements. While SA is rated BB, our spread is edging towards a B-rating (like Turkey), indicating that international markets are concerned about a further sovereign credit downgrade.

YOU WILL BE EARNING MORE INTEREST NOW THAN YOU WOULD HAVE BEFORE THE SOVEREIGN DOWNGRADES …

Now SA needs to pay about 3.5 percentage points a year more for 10-year debt than AAA-rated sovereigns, about one point more than the average BB-rated sovereign.

The bad news is that SA is a high-yield country. The government, and therefore most borrowers, need to pay more in interest.

The Reserve Bank has had to keep policy rates higher to attract capital, support the rand and maintain price stability — and the cost of debt 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 the sovereign downgrades, all else being equal. In fact, you can now earn an unprecedented high real yield. 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 rate cuts. In the US, inflation peaked at 9.1% in mid-2022, and retreated to about 3% by end2023. The US Fed funds policy rate was raised steadily from 0% to 5.5% as inflation surged and is now expected to be cut about 200 basis points to 3.5% in 2024 and 2025.

In SA, inflation peaked at 7.8% in mid-2022, falling to 5.3% this January. The Reserve Bank raised its repo rate from an unprecedented low of 3.5% to 8.25%.

SA market participants now expect the Bank to cut rates by about 100 basis points (to 7.25%) in 2024 and 2025, possibly starting as early as May. At Matrix, we agree that policy rates will decline, but we believe that the timing of SA monetary policy accommodation will lag that of the US by more than the market expects, with rate cuts only in the second half of the year.

With the US real policy rate at historic highs — about three percentage points (300 basis points) above expected inflation — it is at a level similar to SA’s real policy rate, and is placing pressure on the rand.

We expect the Bank to cut its rate once SA inflation settles at about the midpoint of the target range (4.5%) and the US real policy rate is about one to two points lower than SA’s real policy rate.

We also foresee the Bank maintaining its real policy rate about two to three points above expected inflation.

We believe that fixedincome yields will continue to offer good value to investors — especially income funds. Moreover, with high real yields offered by the SA government and major banks it may not be necessary to invest in less liquid, higher risk corporate and securitisation debt to achieve inflation-beating income fund returns.

Our base case scenario sees money market deposit rates down by about 0.75 of a percentage point by end-2024, with most of the cuts coming late in the year.

Furthermore, rates should move lower only 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.

Nominal yields may fall by 50-100 basis points during the latter part of 2024, but real yields offered by income funds should remain as compelling as they were in 2023 (about 3% above inflation).