2017 Compelling Cash Alternatives

2016 Compelling Cash Alternatives - May 2017

Issue 25

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Improving the Outcomes for Cash Investors - May 2017

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Coronation Insights

Coronation Insights

To have a reasonable chance of achieving a better return than a term deposit, investors need exposure to assets with a higher expected return than cash.

In Strategic Income and Global Strategic USD Income this is achieved by taking considered interest rate and credit risk where appropriate (as defined on page 3), and by increasing exposure to alternative sources of return (as defined on page 4), when the likelihood of outperformance is expected to be high. A higher return, however, comes with higher levels of risk. Risk is managed by following a robust and consistent investment process. We apply defensive asset allocation guidelines and conduct careful research to identify individual securities trading below our estimate of fair value. There are, however, no guarantees that the funds will always outperform cash or protect capital over short periods of time.

Our risk objectives in both funds are to protect capital in the reference currency over all periods of 6 months and longer, and to achieve variability of returns that are significantly less than those exhibited by the respective benchmark bond indices.

Most bonds pay a fixed rate of interest over a defined period of time. This rate is set according to prevailing market interest rates at the time of issue. When market interest rates change, the bond’s value in the secondary market will adjust to reflect this change.

When market interest rates fall, the relatively higher fixed rate of the bond already in issue will become desirable, meaning that its market price will increase. However, if rates rise, the now below-market fixed rate of the bond will be less attractive, causing the bond’s value to fall. In this instance, the longer the period to maturity, the bigger the decline in the value of the bond in the secondary market.

Bonds, in their simplest form, can be thought of as a contract or set of promises between two parties – the bond issuer and the lender. The risk for the lender is that the borrower is unable to return the capital at the stipulated time, or is unable to make the agreed upon interest payments.

The credit risk associated with corporate bonds is higher than that of government bonds, as in a worst case scenario, government is assumed to be able to print money to make good on its obligations. Corporates therefore borrow at higher rates than governments. The difference between corporate and government rates is referred to as the ‘credit spread’.

We are highly cognisant of credit risk and only invest in corporate bonds when we are of the view that the yield compensates for the risk, or when there is a general rise in credit spreads. All credit decisions are subject to oversight by Coronation’s independently chaired Credit Committee.

As is clear from the explanations on pages 3 and 4, one is not always rewarded for the additional risk taken or for diversifying into other asset classes. A positive or negative contribution from these asset classes will depend on the prevailing market environment. Figure 1 below illustrates how often some of the asset classes with a higher expected return have outperformed cash +2% (our internal target for Strategic Income) historically.

Our view of changing market conditions, and how we respond in the positioning of our managed income funds, is therefore critical to successfully outperforming over time.