Investors must think about what the world will look like when the pandemic has passed, and which asset classes offer opportunity. How do bonds fit into the mix?
The Covid-19 pandemic has seen monumental swings in investor sentiment. While it cannot be denied there are many investment risks that may persist after the pandemic, there is also great value to be found.
Are bonds attractive enough to offer investors a haven from coronavirus fears, and if so, where are the opportunities?
Before jumping in and investing, Nxumalo says that it is useful to understand the context in which bonds have performed over the last year.
“Most of bonds’ poor performance over the last year can be traced to March 2020: Bonds sold off massively, with yields on the long end touching 13.7% at one point. This was off the back of intense foreigner selling due to coronavirus-related risk aversion and leading up to the Moody’s downgrade.”
She adds that the sell-off was further exacerbated by local fund managers being forced to sell bonds to meet margin calls on bond futures. Yields subsequently stabilised when the South African Reserve Bank stepped in and started purchasing bonds to restore order in the bond market. “Nonetheless, bond yields have remained between 100 basis points (bps) to 200 bps wider than in February.”
But investors have reason to be concerned, as SA’s fundamentals have continued to deteriorate.
“The government deficit, already projected to be the highest in decades, is likely to balloon even more due to Covid-19. Government debt has grown faster than nominal GDP since 2010 – implying that debt was used to fund consumption, rather than investment.”
But has the bad news that bonds have priced in been overdone?
“SA’s credit spread relative to the US is a full standard deviation above its long-term mean. The spread between the ten-year and three-year government bonds is as high as it was in the 1980s – when the country was an isolated pariah state. SA’s real yields are the highest among emerging markets.”
Balancing risk and seeing above-inflation returns
Nxumalo says that as a bond investor, you should look to achieve a decent absolute return in the current environment. Funds with an approach that is uncomplicated and simple, and that seek to generate above-inflation returns without taking on too much risk, can be used to create diversity in your portfolio.
“There are three key risks that need to be balanced: liquidity, credit and duration, the latter of which refers to the interest rate risk inherent in a fixed-rate instrument. Bond prices have an that inverse relationship with interest rates or yields; if yields go up, prices go down and vice versa.”
She adds that at Allan Gray, bond fund managers try to anticipate major trends in the investing environment, with an emphasis on economic health and GDP growth.
“This is important because it has implications for the ability of debt issuers to service their debt. Although not experts in macroeconomic forecasting, we assess the likely direction of inflation as this helps us to determine, for example, if nominal bonds or inflation-linked bonds offer better value.”
Also important are bond market dynamics, in terms of supply from issuers (the government and corporates) and demand from buyers, such as institutional and retail investors, and foreigners. Increased supply in the absence of commensurate demand results in higher yields and lower prices.
“We also consider relative opportunities – such as credit spreads (the margin or relative return above the risk- free rate that investors demand from different issuers)and the yield curve (which is essentially the plotting of the interest rates the government pays at different points in time).”
The Allan Gray Bond Fund has delivered returns above inflation, as well as the All Bond Index (ALBI), over the long term. Its current positioning attempts to strike a balance between attractive real yields and prevailing macroeconomic and fiscal risks.
“We have been cautiously increasing duration to take advantage of the high yields. We have been reducing credit exposure due to unattractive credit spreads given elevated risks. Most of the fund is invested in government bonds, with conservative credit exposures.”
But, why the exposure to government bonds given the burgeoning fiscal risks?
She explains that the anticipated deluge of supply will put upward pressure on bond yields; more debt also results in higher credit risk and higher bond yields due to a larger risk premium. However, the sovereign is still the best credit in the country because the government can print money.
“Furthermore, SA bonds’ attractiveness relative to emerging market peers, together with local multi-asset investors’ interest at these levels, act as a counterforce to an unchecked spiral in yields,” says Nxumalo.
The fund currently has a running yield similar to the ALBI, but with a lower duration – partially in recognition of the fiscal risks abounding, especially considering the current market uncertainty.