Issue: June/August 09
Bonds take centre stage
Most South African investors were somewhat surprised by the rampant performance of bonds in the second half of 2008, which delivered over 25%. This has put bonds as an investment class under the spotlight after several years of underperformance relative to equities, and even to the risk-free asset class - cash. Bonds should form a significant part of any long term investment strategy, given their return potential as well as the diversification and correlation benefits that they add to a balanced portfolio. With the outlook for equity markets being extremely opaque, and the investment landscape across the world looking very different to experiences of the past, trustees need to be cognisant of the importance of bonds in their asset allocation decisions.
Mechanics of a bond
Unlike equities which provide the owner with a share of ownership in a specific company, a bond is a loan instrument whereby the purchaser lends capital to the issuer of the bond for a specified period of time. During this time, the issuer of the bond will pay the purchaser fixed interest payments, known as coupons, at regular intervals. This continues until maturity, when the original loan amount is repaid to the bond holder.
That’s simple enough, so what’s the fuss about? Well, investors have an extremely diverse universe of bonds to choose from. Maturities can vary from 1 year to 30 years, issuers of bonds can range from Government to sub-investment grade corporates, and coupon rates can be fixed, floating, or linked to inflation.
As interest rates change over the life of a bond, so the bond’s price must adjust to account for the fact that the bond’s coupon has been set at a rate different to the prevailing interest rate. Thus, as interest rates fall, the price of a fixed coupon bond rises to reflect the fact that the investor owns an instrument which is paying a rate higher than the current level of interest rates. Similarly, as interest rates rise, the price or return of the bond will fall.
What drives bond returns?
The interest rate at which bonds are issued is the prevailing interest rate in the market applicable to that issuer at that time. Interest rates then move based on inflation expectations and the outlook for the economy. Traditionally, bonds do well in an environment of faltering or retracting economic growth. In this environment, inflation is usually declining and interest rates are moving lower.
Inflation is a fixed coupon bond’s worst enemy as it erodes the real return that the investor is earning. This is why inflation-targeting as an economic policy of the South African Reserve Bank has resulted in more stable bond yields with much lower volatility, thus making bonds an attractive asset class to hold in a portfolio as a diversifier of the volatile equity component.
Why invest in bonds?
Pension funds invest in bonds to provide stability of performance over time and to counter some of the volatility which equity holdings will deliver. As the claim which bond holders have to the bond issuer’s assets in the event of a default is higher up the creditors ladder than for equity holders, the risk involved in investing in bonds is lower and therefore the return over time is reduced, compared to the return and risk one takes when investing in equities. For example, South African bonds have returned 3% per annum more than cash over the last ten years, compared to equities, which delivered 6.5% per annum more than cash. On a risk-adjusted basis, the two asset classes should be very similar in the long-term.
How are bonds likely to perform this year?
Bond yields and thus potential bond returns are fairly attractive at the moment, with the benchmark 20 year bond close to 9%. Inflation is falling back into the Reserve Bank’s target band, economic growth is contracting rapidly and the rates earned from money market investments are falling. This makes for an appealing investment case for bonds over the remainder of the year.
Over longer investment horizons, bond exposure needs to be actively managed in cognisance of the interest rate cycle and the correlation of bonds as an asset class with the rest of one’s portfolio. If the authorities can get inflation back into the target band on a sustainable basis with a high degree of credibility, buying local bonds between 9% and 10% offers extremely attractive real return prospects, which should call for substantially higher exposures to bonds than what many pension funds currently have.
For more information, please contact Francis Wheeler from the RMB Asset Management Fixed Interest team: