• Tonia Pavlou, Sygnia Credit Analyst

Sygnia Enhanced Income Fund delivers stellar returns

In its first six months to July 2019, the Sygnia Enhanced Income Fund has delivered stellar performance of 5.0%, with its benchmark, the STeFI Index returning 3.6%.

Sygnia Credit Analyst, Tonia Pavlou, says “Our aim with the Sygnia Enhanced Income Fund is to provide investors with more stable returns and an element of capital protection, given that income investments have a legal preferential rank ahead of equity investments when it comes to balance sheets. We match an investors’ exposure to the interest rate cycle through their mortgage bonds, vehicle finance, and the like, with income investments that move alongside that cycle.”

The Sygnia Enhanced Income Fund predominantly invests in well-rated South African bank and corporate bonds (income investments) that are floating in nature (they move alongside the interest rate cycle) and provide investors with monthly distributions. The general trends affecting the level of interest earned on these investments is a combination of:

  1. The interest rate cycle: South African banks are mainly funded by retail deposits at a cost linked to the repo rate. This then directly influences the cost at which South African corporates are funded at. If interest rates go up, South African banks borrow at higher rates (pay more to retail investors) and they then lend to corporates at higher rates. The opposite also applies (if rates go down, lending occurs at lower rates); and

  2. Liquidity in the market: If there is a large pool of cash pursuing a small pool of income investments, it drives the interest earned on those investments down.

Over the course of 2019, we have seen a reduction in interest rates (July repo cut) and a high level of liquidity driving the interest earned on income investments lower (the first half of 2019 hit record levels of income investments in the market, with excess cash seeking out those investments). These combined factors have resulted in lower interest earned in the market.

Many investors are questioning what a ratings downgrade could mean for their income investments. South Africa’s last remaining investment grade rating is provided by Moody’s (both Fitch and S&P have rated South Africa as sub-investment grade). In recent weeks, the Eskom bailout has increased the potential negative trajectory of the Moody’s rating, with views that their current outlook on South Africa may change from stable to negative, and their rating from investment grade to sub-investment grade.

RMB Global Markets Research published insights on the impacts of historical SA ratings announcements [05 April 2019: SA’s rating changes: The market’s response]. Our summary is as follows:

  • Existing government bond investment: yield goes up, value of investment goes down;

  • Existing financial sector bond investment: spread increases, value of investment goes down;

  • The financial sector spread moves will generally flow through to the corporate sector as well.

Looking forward, if one applies the S&P patterns to existing bonds, the value of those bonds will potentially reduce, resulting in a loss in value, while any new investments will be at the new values. This trend will occur across the market, however, it is important to note that a downward valuation in government bonds from yields increasing tends to be much larger than a downward valuation in floating financial and corporate sector bonds from spreads increasing. This is because the portion of a government bond that is exposed to changes in yields is much larger than the portion of a floating income investment that is exposed to changes in spreads.

“We are cognisant of the current market dynamics and have built in market protections through balancing our fund with investments in defensive sectors, as well as investing in some vehicles that provide volatility protection in their underlying investments. In the current environment we expect to see continued reducing returns across the market, and we have carefully planned our investments accordingly” says Pavlou.