Bond Investment, is your portfolio actively involved?

Fixed income is a crucial cornerstone of any financial plan to grow long-term wealth. Bonds have, historically been the more stable investment choice, rewarding investors based on the term to maturity and the issuers credit risk. Government bonds have often been referred to as ‘risk free’ since governments are considered to be the highest-quality borrower within a country.

In reality, since the global financial crisis of 2008, bonds, particularly emerging market bonds have demonstrated volatility more commonly associated with currency and equity markets. As a result, investment models often produce underweight bond allocations, regarding them with caution and uncertainty.

In South Africa, Government bond investment expectations can swing dramatically, as the probable end game can seem devastatingly bad, should debt levels spike out of control, credit ratings drop to non-investment grade and capital values become slowly or sharply eroded. On the other hand, when signs of prudent government policy which is focussed on growth appear, demand for bonds increases on the perceived improved economic consequences.

Valuation models are finding it challenging to appropriately gauge the bond risk premia (the excess yield paid to compensate for issuer risk). An efficient market price factors in all the known risks at any point (says the efficient market hypothesis), however, the seemingly uninhibited search for global yield after the financial crisis has often distorted expected bond price behaviour. Local market investors may instinctively react more negatively to political developments than their foreign counterparts adding to these complexities.

In 2013, global bonds fell out of favour after the US Federal Reserves ‘Taper tantrum’, its announced plans to reduce their post crisis stimulus package of buying around $70bn bonds monthly. As a result investors sold out of bonds and analysts warned investors to brace for years of underperformance. In the last week of June 2017 ECB Governor Mario Draghi’s mere hint of tapering European quantitative easing elicited similar painful reactions in bond markets globally.

Locally, the South African Reserve Bank started tightening monetary policy in January 2014, hiking the repo rate by two percentage point from 5% to 7% by March 2016 (the final 75 basis points in the wake of the removal of former Finance Minister Nene in December 2015). During 2016 we saw increased political risks including the decision by Britain to leave the European Union and the election of President Donald Trump in the US. Domestically, political developments including the threat of criminal charges against the former Finance Minister Pravin Gordhan undermined investor and business confidence.

Despite all these developments, Global and SA bonds remained supported and portfolios with underweight bond allocations suffered as a result.

The current fear facing SA bond investors is the seemingly highly probable downgrade of all the SA local currency sovereign credit ratings to sub-investment grade and the capital outflows this would force as SA bonds are ejected from global investment indices. Currently, only Fitch has the local currency rating of sub investment grade (junk) while Standard and Poors and Moodys are precariously on a negative outlook for junk.

SA economic fundamentals are deteriorating rapidly as the economy languishes in a technical recession without any clear plans to improve business confidence and boost economic growth. These conditions aside, bonds still offer value via real returns (the return after inflation) enhanced by forecasts of lower inflation and low economic growth for at least the next two years.

Despite global developments and the ever growing domestic political risks since December 2015 and the countless warnings from analysts and asset allocation models, bonds as an asset class have achieved surprisingly solid returns.

No investment is risk free, and inflation at the very least eats away at your money’s buying power. Bond investing and bond fund management goes hand in hand with inflation and interest rate cycle forecasting. It forms an important part of any longer term diverse investment strategy.

Over time a diversified portfolio for growth should include bonds. An active managed bond fund investment offers access to the asset class with the aim of outperforming the agreed benchmark through active allocation to the constituents of the index in an unconstrained manner.

This more flexible approach should help avoid severe risk events, as the weightings may be actively adjusted across the yield curve as well as into cash where necessary.

While bonds are often higher risk over the short term, particularly when politics are involved, managed actively, they form an invaluable part of any long-term investment portfolio.

Comparative returns over 3 years

James Turp is a Portfolio Manager at Absa Investment Management