As investors we must think about what the world will look like when the pandemic has passed, and what asset classes offer opportunity. Presenting via Zoom webinar, Londa Nxumalo discussed how bonds fit into the mix. You can watch the 18-minute presentation or see below for the key points discussed.
The Allan Gray Bond Fund (the Fund) seeks to generate above-inflation returns for clients, without taking on too much risk. It can be used to create diversity in your portfolio. However, it is important to note that it is not managed to mirror its benchmark, the FTSE/JSE All Bond Index (ALBI), so it is worthwhile understanding how it is positioned, and the approach taken by the portfolio managers.
Our approach to fixed income is uncomplicated
We aim to achieve a decent absolute return. We focus on three key risks:
- Liquidity: The ability to easily buy or sell an instrument at a price close to the prevailing market value.
- Credit: The risk that a borrower may default on its debt, i.e. that they will either not pay interest and principal on time, or at all.
- Duration: Refers to the interest rate risk inherent in a fixed rate instrument. Bond prices have an inverse relationship with interest rates or yields; if yields go up, prices go down and vice versa.
We try to anticipate major trends in the world around us, 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 we are not experts in macroeconomic forecasting, we assess the likely direction of inflation as this helps us to assess, for example, if nominal bonds or inflation-linked bonds offer better value.
We also look at 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).
Over the long term, the Fund has delivered returns above inflation, as well as the ALBI. However, performance has been disappointing over the last 12 months, as we generated returns less than inflation – although the Fund did slightly better than the ALBI.
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 (R53bn). 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.
The market has reason to be concerned, as SA’s fundamentals have continued to deteriorate. The government deficit, already projected to be the highest in decades at February’s Budget speech, 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.
Bonds have priced in the worsening outlook; the question is, has this been overdone? South Africa’s credit spread relative to the US is a full standard deviation above its long-term mean. The spread between the 10-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.
The Fund’s 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, especially 10 years and beyond. We have been reducing credit exposure due to unattractive credit spreads given elevated risks. Therefore, almost three quarters of the Fund is invested in government bonds, with conservative credit exposures.
Some investors may question our exposure to government bonds given burgeoning fiscal risks: 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 has the ability to print money. Furthermore, SA bonds’ attractiveness relative to emerging market peers, together with local multi-asset investors’ interest at these levels, acts as a counterforce to an unchecked spiral in yields.
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 in light of all the unknowns.
To view the Q&A session from this webinar, click here.