What will tomorrow yield for fixed income?


By Melville du Plessis, fixed interest portfolio manager at Sanlam Investment Management.

Global debt dynamics, once an esoteric subject of interest to macro-economists, only now appears to be in vogue and the subject matter has been covered en masse lately.

We saw unprecedented fiscal and monetary policy responses after the 2007 to 2008 global financial crisis – with fiscal stimulus and budget deficits leading to an increase in debt levels worldwide.

Quantitative easing and the US Fed’s zero interest rate policy also served to prop up the price of government bonds and kept yields at artificially low levels – potentially also leading to inflated asset prices elsewhere in the financial system.

This ‘unsustainable reality’ was brought squarely into focus as bond yields rose sharply on the news of the Fed’s intention to taper its bond buying programme in September 2013. But interest rates are today still at their lowest levels in history.

An exceptional bull run in bonds

Global bond yields have been grinding lower for the last 35 years. It has been one of the longest bull runs in history with total returns from global bonds over the last few decades comparable to equity market returns – and at times even beating them for extended periods.

The returns investors have seen in global developed market bonds cannot be expected again. And with global interest rates at such low levels it is difficult to see how this will turn out to be a good investment years ahead.

Many have even questioned whether a bond bubble is looming as a result of central bank policies. The unintended consequences are also a concern: low interest rate policies may have spilled over into other asset classes leading to overinflated prices elsewhere.

We have reached a point in history where some debt instruments even carry negative interest rates. This is counterintuitive: you actually have to pay someone to lend them money! During the last few years the amount of negative yielding debt increased significantly with the total amount peaking at around $13 trillion during the second half of 2016. It is a staggering amount and the thought of negative yielding securities on this scale was previously inconceivable by many.

Two important changes over the last hundred years or so is the development of the global economy, and technological progress. The implementation of negative interest rates is now possible on a scale which was previously unimaginable.

The vast amount of negative yielding debt outstanding is testament to advances and developments which enable previously identified concepts on a much grander scale. We have crossed the zero lower bound on interest rates and the use of new policy options are redefining the boundaries.

One would think that all our modern tools and developments would have been better able to assist us in understanding and solving some of the current geopolitical frictions, financial market dynamics and economic challenges we are faced with. But the world is an increasingly complicated place. To make some sense of the debt and yield dynamics requires an understanding of macroeconomics, financial markets, regulatory trends and policy-making frameworks.

So where do the opportunities lie?

A good starting point is to look for investment opportunities that offer a good margin of safety, and then keeping a close eye on valuations and fundamentals as they change over time. It is also important to make a distinction between local and international bond valuations.

Local bond markets can run counter-cyclical to other international or developed market bond markets. In fact, SA long bonds are still offering among the highest local currency real yields in emerging markets.

While acknowledging the political and macro challenges, now may be a good time for investors looking for a stable form of return.  Even if inflation settles at the top end of the 3% to 6% inflation target, a real return of 3% is on offer. This could be particularly attractive given the low real returns available in equity markets, as well as global bond markets.

It’s about real yields

While on the surface it may seem that developed market government bonds may offer some form of relative protection against weakness in other asset classes, it’s important to consider what price you are paying and what the potential outcomes may be down the line, says du Plessis. Always allocate capital in a sensible way, taking cognisance of the potential risks and rewards.

For us it’s about the real yield, i.e the yield that you earn above inflation. What we are seeing are higher real yields in the local market. So, you’re getting a return above inflation, which is a good thing.

During the previous few years it was not so straightforward how to get a real return in South Africa with the policy rate cut to a low of 5% and inflation was sticky at the upper end of the target band for sometimes extended periods and even above 6% at times.

Now we’re finding yields of above 9% while inflation is moving down from 6.5% last year to levels of around 5.5% in 2017 and 2018. So we are seeing yields above inflation for the next few years, which we think is a good opportunity for investors and savers.

South African government bonds offer an attractive yield compared to developed markets. From an investor’s point of view this starts looking attractive, however from the government’s point of view it is not a good picture if your borrowing costs have increased structurally for longer – this adds to the fiscal burden and can even bring fiscal sustainability into question.

As far as SA inflation-linked bonds (ILBs) are concerned, the SA government is in effect in control of the rand printing press so the default risk on rand-denominated ILBs should also theoretically be lower, as long as the inflation-linked component of the SA government’s total debt stays at a reasonable level. Currently it is at 24%.

There is probably more risk with the accuracy of the measurement and the measurement methodology of inflation, especially during periods of very high inflation or hyper-inflation. If this is a problem, then the credibility of the inflation adjustment applied to these bonds would be compromised.

We still prefer SA conventional bonds to ILBs given the high inflation breakeven rates priced in by the markets.