In the current low return environment, South African bonds have been incredibly resilient. Over the past five years, top-performing funds like the Absa Bond Fund and the Allan Gray Bond Fund have given investors returns of around 9% per annum. That is an above-inflation gain of 4%.
Over a period when the FTSE/JSE All Share Index has only marginally outperformed inflation, that has been an excellent return, earned at relatively low risk.
“If you look at asset allocation funds that have done relatively well over the past few years, most of them have been overweight bonds and cash to some extent,” points out Mark Dunley-Owen, co-fund manager of the Allan Gray Bond Fund.
Local bonds have been an excellent place for investors to find some respite from the low returns across other asset classes. However, it is important to keep this historic performance in context.
“Cash and bonds can outperform equities over the shorter term,” Dunley-Owen points out. “But that is unlikely over the long term.”
This is particularly the case because fixed income yields in the local market have been exceptional. The interest you can earn on cash is higher than inflation, which is not the case in most of the rest of the world. In many developed markets, yields on cash deposits have been negative.
Yet despite this environment, South African investors in general have perhaps still not warmed to investing in the bond market as much as one might expect.
“South Africa has generally been underweight bonds as an asset class because of how good our equity returns have been historically,” points out James Turp, the head of fixed income at Absa Asset Management. “In recent years investors have also been a bit shy of going into bonds due to the political risk and all the focus on our credit ratings. So it is an asset class that investors are wary of.”
Returns from local bonds have, however, defied investor pessimism.
“I think there are two things that have been unique over the last few years that have contributed to this,” Dunley-Owen says. “The first is that despite the troubles the country has, the one thing that has been very well controlled is inflation.”
This has remained almost constantly within the South African Reserve Bank’s target band since 2010, and that has supported the bond market.
The second is that the risk premium foreign investors have demanded from South Africa has increased, keeping local yields high even in an environment of low yields globally.
“If you look at similar countries to South Africa like Brazil and Russia, their 10-year bond yields moved have from roughly 9% to 7% over the last year, whereas local yields have stayed at 9%,” Turp notes. “So relative to those markets our risk premium has increased. That’s not necessarily good from a country perspective, but it has been good news for new local investors because technically speaking government debt is the zero risk asset class, and yet you’ve been able to enter at these high yields.”
Foreigners searching for yield have also ensured that there is plenty of demand in the market.
“The extra liquidity in the system from quantitative easing has forced yields lower globally,” Turp explains. “So any debt offering high yield is in higher demand relative to its risk. With something like 20% to 30% of global bonds giving a negative yield, anything with a rich yield like ours, given our liquid and developed financial system, is attractive.”
SA’s bonds are also the highest yielding in the FTSE World Government Bond Index (WGBI). This means any fund with the WGBI as its benchmark would be hard-pressed to outperform without exposure to the local market.
Still, however, investors remain worried about the risks in local bonds. Their primary concerns are the country’s deteriorating fiscal position and the likelihood of a credit downgrade from Moody’s following the 2020 budget.
“The question is always whether these are priced in, but no one can really answer that,” says Turp.
However, as Londa Nxumalo, co-fund manager of the Allan Gray Bond Fund points out, there is reason to believe that investors do have some margin of safety.
“Arguably the pessimism is somewhat reflected in price levels,” she says. “Brazil has a credit rating two notches lower than South Africa, yet our yields are higher. So the market is already reflecting sentiment at current levels.”
She also feels that a downgrade from Moody’s will be managed by the market.
“If South Africa dropped from the WGBI then you would see outflows from index trackers and some active investors who are still holding our bonds because the opportunity cost of not holding them has been quite high,” Nxumalo says. “But that being said we do have a pool of investors in this country who may be forced to repatriate money as the rand weakened, and some of that would be directed to bonds. So we don’t expect a spiral in yields.”
The Allan Gray Bond Fund was recognised as the best bond fund at this year’s Morningstar Awards. The Absa Bond Fund was runner-up in the category.