Roshen Harry

Portfolio Manager

June 2018

Enhancing your investment income

Article Summary

Enhanced income funds have become a popular choice for investors – but to get the most from them, investors need an appropriate investment horizon.

Enhanced income funds are generally designed for investors looking for a relatively steady and high income return of around cash + 2% per year, along with low investment risk. This should come with moderate capital growth and some degree of capital protection, although neither is guaranteed. These funds are positioned to be one step higher on the risk/return spectrum than money market funds, which are considered to be the lowest-risk option and typically offer a return equivalent to cash (as measured by the STeFI Composite Index) with little potential for capital growth. To get the most from enhanced income funds, investors need an investment horizon of between one to three years. At Prudential we view this medium-term timeframe as essential in achieving the additional returns over cash given the construction of the Prudential Enhanced Income Fund. 

Enhanced income funds have become a popular choice for investors in the last few years, and assets under management in this category (the ASISA Multi-Asset Income sector) have experienced significant growth. This has been due to South Africa’s relatively low interest rates from 2010-2014, given the prospect of earning poor real (above-inflation) returns from cash investments like call accounts and money market funds.

Graph 1 illustrates how cash, with a return of 6.4% per year, has barely beaten inflation (at 5.2% per year), compared to the target of cash + 2% (grey line at 8.4% per year). Meanwhile, the Prudential Enhanced Income Fund (red line) has outperformed strongly with a 9.5% per year return (before fees) since its inception in 2009. The fund has outperformed our target of cash + 2% by almost 1% per annum since inception.

How do enhanced income funds beat cash returns?

To achieve their cash-beating income levels, enhanced income funds must invest in somewhat riskier instruments than cash. Remember, there is no free lunch in investing: with extra reward comes extra risk. So they invest not only in very short-term, low-risk cash instruments, but also in longer-term government and corporate bonds with maturities mainly of between 12 and 36 months – even out to 10 years. Borrowers must pay higher interest rates for these longer maturities because of the higher risk involved. And borrowers with weaker credit ratings must also pay more for their higher risk (termed “credit risk”). 

These funds can also include inflation-linked bonds and listed property, as well as offshore instruments, depending on the client mandate. Fund managers combine different maturities and credit ratings of the underlying securities to balance their fund’s overall risk/return parameters and achieve the desired return target over time.

What types of funds are available?

Enhanced income funds can be constructed in a variety of ways, given that each fund manager will have their own established investment philosophy, methodology and standard of risk tolerance. This means that there are myriad fund offerings in the ASISA Multi-Asset Income sector, although most aim for an annual return of around cash + 2%. The different manger approaches to delivering this target broadly fall in to two camps: those funds that take a lot of credit risk and those that use asset allocation into other income-producing assets such as longer-dated bonds and property to add value. 

At first sight the approach of credit enhancement (lending to lower-rated companies in order to achieve higher yields) has the additional advantage of lower volatility. However, this is a misleading impression of price stability – it only comes about because these corporate bonds do not trade very often. Meanwhile, the asset allocation approach invests in assets which are traded daily; consequently their price moves are a more honest reflection of ‘true’ value.

Fundamentally different

We need to stress that our approach differs fundamentally from many competitor enhanced income offerings that aim to deliver above-cash returns. The Prudential Enhanced Income fund informally aims to deliver a return of the STeFI Composite Index + 2% (before fees), although its formal benchmark is the STeFI Composite Index, and has a secondary objective of avoiding capital losses over any rolling 12-month period. Since inception, the fund has underperformed cash only once, and narrowly missed its cash + 2% return target on two occasions. We expected this underperformance, and during times of market stress were able to actively acquire assets cheaply, benefitting the subsequence fund performance.

The fund achieves its two targets by buying income-producing securities from a range of issuers, ensuring a high-quality, well-diversified portfolio that is not concentrated in any one issuer. We are very strict with the credit quality of the securities we buy, instead opting for debt instruments with longer maturities to help boost returns above cash. We identify debt issues across a range of maturities that we believe to be undervalued when measured against our long-term valuation framework. For corporate borrowers, this analysis includes an assessment of the credit quality of the company, and the terms and conditions of the debt issuance, among many other criteria. Because of our strict approach to credit risk, we buy longer-dated bonds from high-quality corporate issuers in order to add enough yield to reach the fund’s return target.

So at Prudential we use a hybrid of the two approaches above to manage the Prudential Enhanced Income Fund. We have a track record of delivering asset allocation gains over two decades and we believe this is a useful tool for adding value. Additionally, we have a team of dedicated credit analysts and understand that investing in quality companies that we expect to be around over the long term adds value to clients. We tend to avoid the higher-yielding, riskier borrowers. For example, we owned no Steinhoff debt because we were uncomfortable with its accounts. Prudential understands that since it is likely that any corporate bond it buys on behalf of clients will be owned to maturity, we must take a long- term view of its credit-worthiness. Equally, short- term gains from higher yields can prove illusory if the company isn’t around in five years’ time to repay its bonds.

As an aside, unlike some other managers we also avoid corporate bonds that are wrapped in opaque structures. On the face of it they appear to be relatively simple debt instruments paying regular coupons, but upon further analysis one discovers that there is additional credit risk being assumed in a poorer credit that we would be uncomfortable owning.

Achieving positive returns 91% of the time

When we investigate the negative months that occurred on 10 separate occasions since 2009, we notice that the recoveries in the months thereafter were fairly pronounced. For example, the fund had its largest negative month in December 2015 when Finance Minister Nene was fired. Following sharp losses in bonds and listed property, it lost 2% that month, but recovered almost all of its loss in January 2016 and delivered nearly 11.2% (before fees) for the 2016 calendar year. More recently, in November 2017 the fund lost 0.3% due to bond weakness and rand strength, only to be followed with a 1.1% return in December 2017.

Nevertheless, we would still caution that investors who are worried about losing capital over periods shorter than 12 months would most likely be better off in a cash fund like the Prudential Income Fund or a money market fund, as there will be times when the fund will experience drawdowns and may underperform money market funds over very short periods.

Returns that beat cash

As valuations allow, the fund takes shorter-term positions against its long-term “neutral” position, which comprises 50% cash, 40% South African interest-bearing assets and 10% offshore (hard currency) bonds. Within SA interest-bearing assets, the fund holds a blend of government and higher-quality corporate bonds, inflation-linked bonds and listed property.

In Graph 2, the red bars above the gold reflect the additional return we have added above the internal strategic benchmark by actively managing the fund’s asset allocation over time, taking advantage of mispriced assets to add or sell them based on our long-term neutral position.

Hence we buy government bonds and listed property when we consider them to be cheap, in expectation that they will gain value over time. As an example, during the immediate aftermath of the Nene-gate saga in December 2015, long-dated government bonds sold off, yielding above 10% when cash funds were yielding marginally below 7%. The Enhanced Income Fund purchased some of these government bonds and sold them subsequently as they increased in price. These kind of trades do add volatility to the fund’s performance, but the investor is rewarded over time for holding these instruments. Additionally, in the third week of December 2015 the fund purchased listed property given the fall in its valuation and the improved return prospect in the ensuing 12 months, based on our analysis. For the subsequent 12 months SA listed property delivered almost 10%.

This approach has so far proved very successful, benefitting investors recently by delivering a 12-month return to the end of 31 December 2016 of 11.2% (net of fees). For the year ending December 2017 the fund delivered 9.5%, meeting its return objectives.

Looking ahead

The first two months of 2018 proved challenging for the Prudential Enhanced Income Fund as it delivered a negative return of 0.2%. This was due to the unfortunate fall in the value of its underlying property investments sparked by concerns over the Resilient stable of companies – the FTSE/JSE Listed Property Index lost 9.9% in both January and February. These losses were compounded by the strong performance of the rand against the US dollar due to the favourable political environment following the ANC elective conference in December 2018.

However, our property analysts now estimate a high double-digit return from property stocks in the wake of their sell-off, which is why we are comfortable with the fund’s 8.5% exposure. At the same time, our offshore holdings in mostly high-quality liquid investments serve as a diversifier, and we are comfortable with the existing exposure. Finally, following the December ANC elective conference government bond yields rallied and the fund reduced its duration to minimise the impact of fixed income volatility on the fund’s performance. We believe long-dated bonds are now fairly valued, and much of their additional risk premium has been removed. 

Despite this short-term drawdown, the fund delivered a stellar 1.5% return in March 2018 and we remain confident that it will benefit from its positioning in bonds and other high-quality interest-bearing securities to meet its return target over the medium term. Equally, we think that, based on current asset valuations, the fund is positioned to deliver on its target of cash + 2% for the next twelve months, barring the impact of unforeseen global events that are impossible to forecast. 

So for investors requiring an income greater than cash, the Prudential Enhanced Income Fund continues to offer a sound solution. It has a strong history of adding value, demonstrating that it can successfully navigate periods of market turmoil.

If you would like more information about the Prudential Enhanced Income Fund or any of our other multi-asset funds, visit our funds page or alternatively, contact our client services team at query@prudential.co.za.

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