Edition: September / November 2015
BONDS

BLACK ECONOMIC EMPOWERMENT

A lesson in basics

Many trustees are not as familiar with the workings of the
bond market as they should be. Help is at hand.

Ask a sample of trustees what they know about bonds and there’s a strong chance that the eyes of several will glaze over. For bonds lack the romance of better-understood equities, where investee companies are household names and the tracking of price movements enjoys daily limelight.

Bonds are different. They’re widely considered to be dull, offering a dependable shock absorber for retirement funds’ investments, and in any case too difficult to follow. Merely mention that their prices go up when their yields go down, and vice versa, to observe the confusion compounded by the myriad bond offerings and the sense of complexity in their pricing.

Yet they demand trustees’ closest attention. For one thing, retirement funds will always have a substantial investment in bonds. In fact, the revised Regulation 28 allows them to invest their entire portfolios in SA government bonds.

For another, there’s the sheer size of the bond market. Roughly half of all issuances are by the SA government. The R1,33 trillion of its bonds in issue means that outstanding government debt equates roughly to 45% of SA’s annual gross domestic product. Huge chunks of this debt are owned by foreign investors and local pension funds, both vulnerable to pressures outlined in the previous article headed ‘Retirement reform’.

Also, critical for trustees’ attention is that a small movement in interest rates can have a big effect on the value of bonds and hence on the value of funds’ portfolios (see box). As it was pointed out by National Treasury in the explanatory memorandum that accompanied the revised Reg 28: “Fixed-interest investments are not necessarily less risky than equities. Their market value has moved in as volatile a fashio as the equity market over the last few years.” Trustees wanting a bottom-up elucidation on the SA bond market would do themselves a favour by availing themselves of the 137-page textbook ‘Bond Market: An Introduction’ by Pierre Faure. Published by the Quoin Institute, it’s available for free download from www.bookboon.com.


Viljoen: step-by-step guide

Henk Viljoen, head of Stanlib’s fixed-income franchise, takes TT readers through a 101 lesson: Markets, he notes, tend to react differently over different periods; say, when the currency weakens or the gold price shifts. This impacts on whether bond yields move in a particular direction, but sometimes they don’t react at all.

Investors in fixed-interest instruments would make a nominal investment to receive interest payments, at pre-determined rates, either monthly or at the end of the instrument’s life. There’s the money market (similar to a call account where the investment can 34 Today’s Trustee September/November 2015 be redeemed within a day or up to one year), and the bond market (typically for longer than one year and up to 30-40 years).

If you buy 100 shares in a company for R100, and its financial results are better than expected, the share price might be expected to appreciate. But in the case of bonds, you buy at the market rate (yield to maturity). You buy for say R100 with a 10% coupon (yield to maturity of 10%).

Then interest rates go down to 9%. The bond will still yield 10% (after the 10% coupon), so you’d need to pay a premium. Thus, if rates go down, the price of the bond goes up; if rates go up, the converse happens and the price of the bond will reflect a discount.

Of the SA government’s issuance, most is in nominal bonds (with average lives of six to eight years) that pay six-monthly coupons. Inflation-linked bonds – ideal for pension funds’ liability-driven investments because they pay a real return above inflation as measured by the consumer price index – comprise about 23% of government’s issuance.

Other big borrowers are SA’s state-owned enterprises (SOEs). They borrow from the bond market because they need money for projects that have long time horizons. For example, an Eskom issue would be beyond 10 years because power stations are expected to have lives of over 40 years.

Some of the instruments issued by SOEs carry a government guarantee; other SOEs issue bonds off their own balance sheets. The two main issuers on government guarantees are Eskom and Sanral. When a SOE uses a government guarantee, the spread (difference between buy and sell rates) is much narrower than if the bond had no government guarantee. The cost of the guarantee, market talk suggests, is around 30 basis points (0,3%). So if the differential is more than 30bps, it pays the SOE to have a government guarantee.

Sanral is a case in point. Having previously issued paper without a government guarantee, it’s been able to borrow because it more recently issued paper with a guarantee. The spread has widened by around 30bps from the SOE’s pre-turmoil days.

Over the past six years, foreigners have become large investors globally in the debt of emerging markets. Because SA has a bond market that’s highly developed and liquid, it’s been a beneficiary of these flows. The ease with which foreigners have been able to buy and sell rand-denominated instruments (where they can hedge against the currency) has given them comfort on SA government bonds.

Current estimate is that foreigners own 30%-35% of SA bonds. Their participation has a significant impact because of SA’s large current account and budget deficits. Foreigners who invest in emerging markets, with ratings similar to SA’s, have latterly become more cautious in their allocations.

Should there be a significant deterioration in SA’s twin deficits, or unsound political developments, SA bonds are vulnerable to selling pressure. Interest rates would have to go up, meaning capital losses for holders of long-dated fixed-interest instruments. Most probably, were foreigners to disinvest, both the equity and bond markets will be impacted negatively at the level of loss in absolute value.

Other than foreigners, large holders of SA bonds are banks, insurance companies, pension funds and unit trusts. Banks and insurers hold them partly for regulatory and liabilitymatching purposes; pension funds and unit trusts mainly for their relative attractiveness on value.

Reg 28 allows for a large allocation of pension funds’ investments to this conservative asset class. However, if these funds expect rates in the bond market to rise, their preference might switch more to the money market. But they’d typically allocate a greater weighting to the bond market provided it offers returns that they consider attractive.

Footnotes

In mid-August came the largest-ever devaluation by China of its currency. Before it triggered turmoil in global markets, two topical observations help to provide context for bond movements that once were more stable:

  • In SA, points out Investec economist Annabel Bishop, during the third quarter of this year (to Aug 3) foreigners were net sellers of SA bonds. By value, R5,3bn (net of purchases) had been sold by foreigners since the July meeting of the SA Reserve Bank’s monetary policy committee. Foreign demand, she finds, is “dwindling”;
  • In the UK, according to the Investment Association, volatility in bond markets has prompted investors to withdraw from fixed-income funds on a grand scale. For two consecutive months they’ve been the worst-selling asset class. The FT quotes a fund manager: “If the past 30 years has been a one-way traffic for bond investors, the last six months has been anything but.”

FOR ILLUSTRATION

Okay, a befuddles trustee might cry, just give us an example of what will happen to the value of R20m that my fund invests in a SA government bond. Melville du Plessis, bonds portfolio manager at Sanlam Investments, provides it by taking the R2023 bond at various dates assuming reinvestments of the coupon:

Check the volatility, and explain it further

 

Total Market
Value with
Reinvested
coupon (RHS)

R2023
Yield
R2023 Years
to Maturity
2014/10/01 R 20 000 000 8.14% 8.42
20145/02/01 R 22 122 084 6.85% 8.08
2015/07/01 R 21 204 541 8.13% 7.67