South African bonds are currently offering the highest real yields in the world. The yields on long-dated local bonds are as much as 9.0% higher than equivalent instruments in the US, and 11.0% above those in Europe.
These yields are reflecting the market’s view of the risks facing South Africa’s fiscal position. However, in the view of PortfolioMetrix’s South African head of investments, Philip Bradford (pictured), they are also offering investors a meaningful opportunity.
“My UK colleagues are so jealous of our bond yields,” Bradford said. “For foreigners, it’s a no brainer for local investors to invest in SA bonds.”
South African investors, he believes, are often too “emotionally involved” when assessing the country’s risk factors. Foreign investors, however, are seeing through the noise and rationally focusing on the opportunity relative to the risks.
Locking in yields
“Very often, you have to swim upstream as a fund manager and go against what the average investor would want to do,” said Bradford, who manages the PortfolioMetrix BCI Dynamic Income fund. “That means buying local bonds when the trouble is happening, as we have done in the last couple of weeks.
“We went from our lowest bond exposure ever to doubling that in a week or two because markets had sold off and we could lock in yields of around 11.5% for our investors.”
The yield on the South African 10-year government bond rose from 8.4% in early February to peak at nearly 9.6% towards the end of March. This hurt short-term returns, as prices fell, and raised concerns amongst some investors about the asset class.
However Bradford thinks that the risk in bonds is not as high as people think.
“Because the value of fixed-rate bonds changes, investors tend to apply a similar risk lens as they do to equities. But I look at bonds quite differently. I know that a bond is totally mean reverting. If it does sell off, I know the cash flow is still going to come through. It’s still a guaranteed instrument. The capital value does move around, but I know that it’s going to come back by the time it matures.”
The critical factor in any bond investment, Bradford emphasises, is the yield.
As the below graphic shows, over nearly 20 years the contribution of capital returns to the total return on the FTSE/JSE All Bond Index (Albi) is actually slightly negative. The entire return has come from the income.
“With bonds, what you have is a guaranteed income stream at a fixed rate,” Bradford said. “And, over time, that is what you are going to get.
“I don’t go into bonds expecting capital returns.”
This is what many investors miss when they see bond prices falling.
Bonds are boring
“Because people are applying an equity mindset, they think that when bonds sell off 5% it’s a disaster. If you buy a South African bond that yields 10% and the capital falls 5%, over 12 months you still get a net 5% return. But what’s important is that the next year you are going to get that 10%, and the next year you get another 10%. Eventually that capital is going to come back too.
“This is partly why bonds are particularly misunderstood. It is because they are so boring.”
He added that country-specific risks may also be over-emphasised when it comes to investing in local bonds.
“There are obviously fiscal risks,’ Bradford said. ‘But if things do get much worse in South Africa, bonds are not necessarily the worst place to be. The thing that will give is our currency.”
And, historically, South African bonds have still been able to post positive returns in periods when the rand blows out.
“I think we’re a long way away from what would be seen as a local currency debt default in South Africa,” Bradford said. ‘But I’m confident that in that scenario, bonds would be balanced off against the currency in a diversified portfolio.”
With yields at current levels, Bradford also believes that investors should be focused on the longer-term opportunity.
“From these levels, your likely returns are about 8.0% per year over five years,” he said. “Your best scenario returns are north of 12.0%. Even if bonds have a bad year, you are probably still going to beat cash comfortably over 12 months and earn a positive real return. If they have a good year, you are going to receive equity-like returns.”
These high yields also give income managers the ability to construct portfolios for specific outcomes, without having to take on excessive risk.
“Because longer-dated yields are so high, you only have to invest part of your portfolio into them to get a really a good inflation-plus return,” Bradford said. “If you give me R100 today and you want a return of 6.0%, which is inflation plus 3.0%, I can take R50 and buy one of the longer-dated bonds, at 12%. That already gives you your 6%.
“That means I could invest in the rest in bank floating-rate bonds, giving me 4.0% to 6.0%, or even sit in cash. That smooths the return. Currently I can give you 7.5% with only half of your money invested in fixed rate bonds and the rest in cash.
“Having a flexible approach like this allows us to keep our yield similar to the Albi, but keep a lot back in cash. That means when there is a sell-off we can avoid it, and then invest to lock in those higher yields.”
Patrick Cairns is South Africa Editor at Citywire, which provides insight and information for professional investors globally.
This article was first published on Citywire South Africa here, and republished with permission.