Lyle Sankar | The silver lining for fixed income investors
Fixed income investors find themselves confronting three key factors that are complicating decision-making in the current environment. Money market rates are at a high, but with falling inflation it seems unlikely that these will be maintained indefinitely. Secondly, many consider longer-dated government bonds as a risky choice and are hesitant to invest further out along the yield curve. And lastly, with so much uncertainty locally, some investors are tempted to rather try and take advantage of high yields offshore.
We believe that patient fixed income investors can be well rewarded even in the current uncertain macro environment, with the ability to lock in the prevailing high yields and achieve inflation-beating returns. With bond yields pricing in a significant degree of negative news, investors will need to focus on the most important aspects that will drive returns to enjoy the benefits of the current yield environment.
Money market returns are likely to moderate in the future
Money market rates have played their role to perfection as a safe capital store offering progressively higher yields during the South African Reserve Bank’s (SARB’s) aggressive rate hiking cycle. But investors should be asking themselves whether the SARB will continue hiking the repo rate given moderating inflation, and with other emerging markets beginning to cut rates. While we don’t believe the SARB will cut rates as fast as it hiked and is likely to keep the repo rate ahead of inflation, money market yields are at risk of trending lower. Meanwhile, bond returns should respond positively to a lower repo rate – driving significant relative outperformance of long bonds.
The yields in local government bonds provide significant capital protection
While SA’s government debt (forecast to reach 80% in the near term) is not out of line with other emerging markets, low growth projections lead many to question whether government bonds will remain a safe store of capital. While we do not intend to underplay the importance of continued fiscal prudence, taking a closer look at the metrics, we don’t believe that a debt crisis is likely in the medium term. South Africa has a very well structured debt profile with only around 12% of long-dated bonds maturing over the next four years. The SARB has also had a world-class track record since implementing its inflation-targeting mandate and inflation is less likely to exceed target levels on a sustained basis.
If a debt crisis is a low-probability scenario and inflation averages 5.0% to 5.5%, investors who buy these government bonds at an average yield of 12% today will earn inflation plus 7.0%, which is on par with long-term equity real returns. Importantly, this is not premised on a high growth environment in SA. The rate cutting cycle (and potential for a slightly better environment) further adds optionality of capital appreciation to the investment thesis.
Developed market rates offer more risk than reward
US yields are now five times higher than during the Global Financial Crisis (GFC), and thus many investors are wondering if it isn’t time to consider offshore fixed income assets. While we do see (and use!) the diversification benefits of offshore assets, we would be cautious of allocating capital to developed market bonds. Investors make a critical call when shifting assets offshore, as we have seen in the past year – both on the valuations of the assets they buy and on the currency risk.
In our view, developed market bonds pose a significant risk of capital losses as key markets (the US, UK and Japan) continue to run budget deficits against substantial debt maturities. The US has approximately 46% of its debt maturing in the next four years. This creates a cocktail of significant bond issuance at a time when yields are five times higher than recent years, producing a spiral of interest costs. We also don’t believe developed market inflation will be contained at the 2% target rate, given that supply side constraints will take multiple years of investment to resolve. These headwinds are likely to force yields higher, resulting in very poor returns for investors.
Secure the silver lining by ensuring your portfolio is correctly positioned
While money market and offshore rates may currently appear attractive, we believe these areas have to be navigated with care, given the uncertain macro environment. We believe multi-asset income funds are well placed to provide investors with inflation-beating income exposure in a manner that preserves capital and manages short-term volatility. More importantly, PSG Asset Management’s dynamic approach in our multi-asset fixed income fund means that we evaluate the environment on an ongoing basis, and adjust portfolios (and tailor our assumptions) as the environment evolves.
This is especially important, because to unlock the silver lining that is currently on offer, investors will need to ensure that they partner with an investment manager who can assess the risks and opportunities in the market rationally, and construct robust portfolios that take care to manage the risks and avoid permanent capital losses.
PSG’s proven 3M investment process helps to ensure we assess risks and opportunities in a disciplined manner and construct robust investment portfolios suited to challenging environments. This approach has been instrumental in helping to ensure we deliver all-round investment excellence, including for our fixed income investors.