Raazia Ganie, Executive Head of Investments at NMG Benefits
High interest rates are a cause for concern for many South African businesses and investors. For the country’s pension funds, the impact of the interest rate environment differs widely, depending on their specific strategy.
While inflation is showing signs of returning to the Reserve Bank’s desired 3-6% range, it’s likely that the country will remain in a high interest rate environment for a while longer, as South Africa takes its cue from the US interest rate cycle.
For pension funds, managing high interest rate environments comes down to diversification and having some cash on hand (or liquidity) to take advantage of any opportunities. But over a 40-year period, there will be many varying interest rate cycles in which members will be invested. The important thing for the fund managers is that they balance their portfolios to meet the CPI target over a full market cycle and in turn provide the expected returns as mandated.
In South Africa, the retirement fund market is predominantly defined contribution (DC) driven. These funds generally have multi-asset, multi-strategy portfolios, which are differentiated by varying risk profiles. Members are invested in these portfolios depending on their risk profile or their age.
Defined benefit (DB) funds are a dying breed, and here the strategies vary. Many DB Funds employ liability driven investment (LDI) strategies, which aim to match the liabilities and assets. These strategies are dominated by bonds and generally assets are managed by a specialist LDI manager. The effect of the increased interest rates on these portfolios, in theory, is that both the assets and liabilities will behave in a similar manner and the funding level for such funds would remain stable.
Having said this, both fund types may employ growth asset strategies. The strategy for any fund is as good as its asset allocation, which drives the bulk of the variability of returns. Riding out the high interest rate cycle has many facets, however. Where pension funds have appointed managers with specific mandates, these mandates should have the ability to take advantage of opportunities as they arise. There are also numerous other asset classes such as infrastructure, private markets and even increased offshore exposure which can (and should) be considered.
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While pension funds may start seeing potentially lower returns on specific equities during the higher interest rate environment, pockets of value remain. Some opportunities exist within equity markets, especially for those companies that are able to pass on the inflation increase to consumers. Areas like LDI mandates, which are fixed income focussed, can offer opportunities for fund managers with these specialist capabilities. As real interest rates (that is the difference between interest rates and inflation) go up, the value of the liability comes down. In these circumstances, it may be a good time for pension fund trustees to start thinking about whether they want to outsource liabilities.
If your interest rates are high, your bond prices are low, due to the inverse relationship which exists. If you need to sell out of assets, these are variables you will want to consider where liquidity is required. If you had some offshore equities, for example, it has had a strong run and with the weakening exchange rate you may be able to take profits on these, where it can be done efficiently.
Within the multi-asset strategies, some funds may have income assets and flexible bond funds. These are different types of fixed income mandates, where fund managers will be able to potentially take advantage of opportunities. During these types of turbulent times, one often finds that high yield bonds, for example, could provide good value for fund managers with skill in this area and the ability to identify and avoid bonds that may default.
These are the types of shorter-term decisions pension funds could benefit from. In these instances, it is important that pension funds ensure that the mandate provided to a manager is broad enough to enable the manager to make these decisions and take positions across the full spectrum of fixed income instruments.
Income funds can be seen as a money market alternative for funds who want a higher yield than the average money market. The funds generally have a similar liquidity profile to money markets, while taking slightly longer duration tilts, and may hold both fixed and floating notes. The floating notes enable investors to be able to take advantage of interest rates as they rise by earning the higher interest rates. Money market funds have also seen increased yields, but real rates are not as attractive as they have been in the recent past, when we saw excellent money market rates and much lower inflation.
It’s important to bear in mind that any changes within portfolios come with associated costs. Fund managers must ensure that the opportunity they take will be value additive, net of all trading costs incurred. Otherwise, it may be better to remain in the current positions until a value is unlocked (assuming these are still value adding).
At the end of the day, it all comes down to diversification. Ultimately pension fund managers want to create portfolios that are somewhat agnostic of the current environment and can stand the test of time. There will always be nuances and potential tactical asset allocation to take advantage of. But the goal remains to balance risk and add return in both a rising and falling interest rate environment.