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Your Questions Answered: Fairtree Flexible Income Plus Prescient Fund & BCI Income Plus Fund

The Fairtree Flexible Income Plus Prescient Fund and BCI Income Plus Fund invest exclusively in bonds issued by companies in South Africa and Europe. In other words, the funds are effectively lending money to these businesses and earning interest from them.

So, what are the risks, and how are they managed?

We’ve just seen a default on two corporate bonds in South Africa that were owned by some local unit trusts. This made it clear that a default can hurt a strategy that buys corporate bonds. Does this mean these two funds are high-risk strategies?

The first point to make is that credit defaults are not abnormal events. In fact, investors should expect them to happen. It is almost inevitable that, in the fullness of time, every entity that issues any bonds – whether they are a government, a business or a state-owned company – will default at some point. Argentina, for instance, has defaulted on its debt nine times.

Since we know that defaults are going to happen, it is a risk that we can manage. What you don’t want in a credit strategy is to have a large portion of the fund in the bonds issued by any single company. Because when a default happens, investors could face a big loss. A credit strategy should be highly diversified so that if any single company is unable to pay what it owes, that is ultimately only a tiny portion of the portfolio.

In both the Fairtree Flexible Income Plus Prescient Fund and BCI Income Plus Fund, we hold bonds of more than 400 different companies. By doing this, we diversify the risk of an individual loss.

All the bonds that these funds own are rated ‘sub-investment grade’. Does that mean the chance of them defaulting is high? Could you see a whole lot of defaults in any year?

In both of these funds, we have already seen multiple defaults. Since the Fairtree Flexible Income Plus Prescient Fund was launched just over a decade ago, more than 40 companies in the portfolio have defaulted on their debt.

There are two important factors to note here. Firstly, those defaults are all recorded in the performance of the fund. None of the losses were side pocketed, and none of them upset the fund’s return profile because they were very small positions. Due to the way the strategy is managed, it has consistently continued to deliver stable returns, even though there have been these defaults along the way. That is the way the portfolio is designed to work.

Secondly, the reason that the fund has been able to capture the returns that it has, is precisely because of this risk. Investors are always concerned about the potential for defaults and the losses they could take, and so they demand a higher return for lending money to these companies. However, the amount of risk that is priced in – in other words, the number of defaults that investors expect in any year – has always been lower than what actually materialises. That difference means that a well-run, highly diversified credit portfolio is able to continue to deliver consistent performance even as defaults occur.

Is it safer to invest in government bonds?

The answer is both yes and no. South African government bonds are also currently rated as sub-investment grade. That means that they carry the same perceived risk as the debt of the companies these funds invest in. Going back to a previous point, and without making any judgement on the current state of the country’s finances whatsoever, South Africa will default on its debt at some point. Every entity that issues debt, will inevitably default somewhere along the line.

Of course, governments have many ways to raise money, so when they default, investors are never left with nothing. A company that goes bankrupt, on the other hand, may not be able to pay back much, or at all.

Nevertheless, a bond strategy that only holds South African government debt is a highly concentrated portfolio. If the government defaults, there is no escaping the impact since it has exposure to only that one entity. In a well-run credit portfolio, where diversification is paramount, there is very little concentration risk. As these funds have shown, defaults can and will happen, but that does not translate into irrecoverable losses for investors.


Disclaimer:

Fairtree Asset Management (Pty) Ltd is an authorised financial services provider (FSP 25917). Collective Investment Schemes in Securities (CIS) should be considered as medium to long-term investments. The value may go up as well as down and past performance is not necessarily a guide to future performance. CISs are traded at the ruling price and can engage in scrip lending and borrowing. A schedule of fees, charges and maximum commissions is available on request from the Manager. A CIS may be closed to new investors in order for it to be managed more efficiently in accordance with its mandate. Performance has been calculated using net NAV to NAV numbers with income reinvested. The performance for each period shown reflects the return for investors who have been fully invested for that period. Individual investor performance may differ as a result of initial fees, the actual investment date, the date of reinvestments and dividend withholding tax. Full performance calculations are available from the manager on request. There is no guarantee in respect of capital or returns in a portfolio. Where a current yield has been included for Funds that derive its income primarily from interest bearing income, the yield is a weighted average yield of all underlying interest-bearing instruments as at the last day of the month. This yield is subject to change as market rates and underlying investments change. Prescient Management Company (RF) (Pty) Ltd is registered and approved under the Collective Investment Schemes Control Act (No.45 of 2002). For any additional information such as fund prices, fees, brochures, minimum disclosure documents and application forms please go to www.fairtree.com.

This document is confidential and issued for the information of the addressee and clients of Fairtree Asset Management only. It is subject to copyright and may not be reproduced in whole or in part without the written permission of Fairtree Asset Management. The information, opinions and recommendations contained herein are and must be construed solely as statements of opinion and not statements of fact. No warranty, expressed or implied, as to the accuracy, timeliness, completeness, fitness for any particular purpose of any such recommendation or information is given or made by the Manager in any form or manner whatsoever. Each recommendation or opinion must be weighed solely as one factor in any investment or other decision made by or on behalf of any user of the information contained herein, and such user must accordingly make its own study and evaluation of each strategy/security that it may consider purchasing, holding or selling and should appoint its own investment or financial or other advisers to assist the user in reaching any decision. The Manager will accept no responsibility of whatsoever nature in respect of the use of any statement, opinion, recommendation, or information contained in this document. This document is for information purposes only and does not constitute advice or a solicitation for funds.

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