<strong>By: Dirk Jooste is a Fund Manager at PSG Asset Management.</strong>

<h2>Local investors are opting for fixed income over equity, in a bid to play it safe</h2>

Heightened risk aversion from local investors has resulted in increased demand for fixed income funds, while equity funds have lost much of their appeal. The latest statistics from the Association for Savings and Investment South Africa (ASISA) show that South African Interest Bearing portfolios attracted the bulk of net annual industry inflows for the year ended June 2019, followed by Money Market portfolios. On the flipside, the South African Equity – General category recorded net outflows.

<h3>Shifts in demand have impacted asset prices</h3>

The demand for fixed income funds from investors has spurred demand for fixed income instruments from fund managers. This has resulted in corporate bonds and other credit instruments starting to trade at lower yields. In contrast, as equities have become less popular, the decline in prices has resulted in attractive dividend yields.

Bank securities present a good case study. As shown in Graph 1, credit spreads on both floating and particularly fixed-rate negotiable certificates of deposit (NCDs) from local banks have narrowed i.e. yields on these instruments are lower and closer to those offered by government bonds of the same maturities (for fixed-rate NCDs) or corresponding JIBAR (short-term interbank) rates (for floating-rate NCDs). In contrast, dividend yields on bank shares have gone up.

Graph 1: Spreads on bank NCDs have narrowed, while dividend yields on bank shares have increased

<img class="aligncenter wp-image-140036 size-full" src="https://www.cover.co.za/wp-content/uploads/2019/09/unnamed-23.png" alt="" width="1808" height="1010" />

Sources: PSG Asset Management, Bloomberg

<h3>Narrowing credit spreads have reinforced the importance of a solid credit process</h3>

Buying with a sufficient margin of safety – ensuring that yields compensate our clients for the associated risk taken – is a cornerstone of our fixed income philosophy. Recent credit spread movements such as those in bank NCDs have therefore prompted us to re-evaluate exposures to the credit market, to ensure that both fund holdings and position sizes remain appropriate. Where we are no longer comfortable that the margin of safety offered is adequate, we are taking advantage of current market appetite to sell into strength.

<h3>Higher dividend yields have presented opportunities</h3>

We are applying some of this capital into high-quality local shares that have come through our investment process and are now offering attractive dividend yields. In the prevailing environment of fear, these shares are available at low prices, providing a wide margin of safety to their intrinsic values. We also expect steady growth in their dividends in future, implying both an attractive current yield and protection against future inflation – a rare combination.

<h3>Investing countercyclically allows long-term investors to capitalise on shifts in sentiment</h3>

Large moves in sentiment that drive broad-based changes in investor behaviour pose risks as well as opportunities. What becomes popular also becomes more expensive (and offers a lower margin of safety), while what gets left behind may appear unappealing but in fact offer misidentified value. Bank NCDs are traditionally considered to be very low-risk investments, but with their spreads narrowing this may not currently be the case. On the other hand, many domestic equities – part of an asset class considered to be high-risk – are priced with such a wide margin of safety that they actually present a low-risk opportunity. Anomalies such as these create attractive prospects for long-term investors.