Issue: December 2006/ January 2007
Michael Streatfield, strategist at Investec Asset Management

Investec Asset Management strategist Michael Streatfield, CFA, advises a fresh look at the domestic bonds space. The ‘one size fits all’ bond surveys are masking the evolution in bond portfolios, especially around credit risks.

In the past, trustees needed to pay little attention to bonds. They were merely a filler to lower the overall risk in balanced funds. No longer! In South Africa the bond space has significantly moved on. How should trustees now be looking at it?

These days, adding to the confusion, current bond surveys round up all the fixed-income products into a single corral. This grouping is not homogeneous. It contains low-risk ponies next to wild stallions, not to mention some zebras and the odd camel.

Trustees must recognise that the whole space of bond products has massively evolved over the past five years.

Why the evolution?

Because of lower inflation, and thus lower interest rates, bond portfolios must work that much harder. As you can imagine, it’s easier to get a return 1% above the All Bond Index when the yields are 15% as opposed to 8%.

So bond portfolio managers have been looking at a wider set of portfolio instruments to find returns as outperformance from conventional government bonds becomes scarcer.

For example, managers take on increased credit risk by buying bonds backed by companies and not only those guaranteed by government. Companies rely on future profit growth to repay their bond investors. This is not as safe a prospect as borrowing from governments (which can always raise taxes to repay their bonds). The yields on corporate bonds provide more reward to investors but expose them to fresh sets of risk.

Changing market composition

In South Africa, government issuance of bonds has been falling while companies have taken advantage of lower interest rates to issue their own bonds. As proportions of government to corporate bonds in issue change, a significant market shift towards the credit side has been caused. Five years ago, corporate bonds in issue comprised 5% of the market; today it is 36%. This is more in line with global norms where markets are split on the ratio of 60% government bonds to 40% corporate.

Credit requires different thinking. It is a hybrid that depends on the success of the individual company and not simply interest-rate risks. The ride can be bumpy! In 2005, the credit side did very well as the stock market and economic conditions were rosy. Demand for credit was greater than supply, leading to improved yields. This smooth ride was upset in June 2006 when interest rates rose unexpectedly.

Trustees must be wary of superb returns from their core “bond fund”. This may be driven by credit. However, when credit-related events happen, big falls can result from what was considered a safe part of the overall portfolio.


  • Kick the tyres. Find out how your bond fund has changed over time. Ask what is driving performance. Understand chasing returns means entering new arenas of risk;
  • Are you on a bucking bronco? Credit reversals can be quite savage, leaving investors with bonds that are well termed as “junk”. Trustees must be aware that we have not yet seen a full credit cycle. Understand the fund’s risk limits;
  • Performance surveys need to evolve. Previously, they’ve been able to focus only on duration. Now, the field must be differentiated to show the risks of credit and flexible products. Increased credit is here to stay, requiring good jockeys to ensure that bonds add to retirement security.

What is in a name?

As the bond space has dynamically evolved, the product range has necessarily expanded (compare Figure A with Figure B). The problem now for trustees is that a product name might not sufficiently describe the product’s strategy and risk. Trustees will want to pick the best fund in the bond survey, but “best” at what?

Product names can be misleading. They might describe what the product was when it was created, but today its underlying investment strategy may have moved on.

Multiple levers

How do trustees sort out this herd of bond funds? It comes down to understanding what risks are driving the returns. Is your portfolio manager taking more risk with

  • Duration (bigger bets around the benchmark)?
  • Credit (increased yield by investing in less safe corporate bonds)?
  • Off-benchmark bets (listed property, dividend income, derivatives)?

Or a combination of all these?

Navigating the bond space

It seems there are three broad sets of funds:

  • Core bond space: This is the “old-fashioned” lower-risk bond fund. These funds generate modest returns by focusing predominantly on duration bets (interest rate moves). Emphasis is on safety with limited credit exposure;
  • Added credit: These funds take on a wider ambit and actively include corporate bond exposure. Credit exposure is still investment grade relying on listed instruments. These funds also take on more risk.
  • Flexible: Here the sky’s the limit. Few rules are placed on the fixed-income portfolio manager, except to perform. These fixed-income funds use the whole range and seek many different sources of return. They can include walking off the beaten path into unlisted instruments or other assets, sensitive to interest rates, such as preference shares.

The variety of risks and returns will diverge widely. Trustees must therefore be acutely aware of the risks being undertaken on their behalf. Outperformance is great but must be measured appropriately. Our corporate bond market is still young and has not yet experienced a full economic cycle. We have not yet seen how a recession can put businesses and corporate bonds under stress.

South Africa’s bond market is highly liquid and competitive. Expect more innovation and change in the fixed-income space, promising to take retirement funds to new destinations. Enjoy the trip. Bond Voyage!