Lyle Sankar | Fixed income investor FAQ: avoid overpaying for ‘safe’ assets, and think independently

Investors are grappling with a volatile global macroeconomic environment and a barrage of issues in South Africa. For fixed income investors, this challenge is amplified by the need to preserve capital, manage short-term volatility and at the same time, attain sufficient yields to meet income needs.

In talking to fixed income investors, we have noted some recurrent themes:

• With money markets having offered safety and growing yields over the last year, why take more risk in longer-dated bonds?
• Longer bonds are volatile, and investors are concerned about losing capital.
• Hard currency yields may seem to be the safer bet at 15-year highs of 4% to 5%.

We would like to argue that to navigate the challenges facing fixed income investors successfully, they need to think independently and avoid overpaying for investments based on potentially unwise perceptions of 'safe' assets.  Most importantly, however, they need to avoid areas which pose a higher risk of permanent capital loss. With this in mind, we examine the key questions that local investors raise.

Money market offers high yields, why move into longer-dated bonds? 

Money market rates have played their role to perfection as a safe capital store that offered progressively higher yields during the South African Reserve Bank's (SARB's) aggressive rate hiking cycle. The question investors should be asking themselves is whether the SARB will continue to hike the repo rate with the latest inflation print being 4.7%, below expectations of 4.9%, and with other emerging markets beginning to cut rates. While we don't believe the SARB will cut rates as fast as they hiked and are likely to maintain the repo rate ahead of inflation, we are now at a point where money market yields are at risk of trending lower while bond returns should respond positively to a lower repo rate – driving significant relative outperformance of income funds.

Will local government bonds deliver for investors? 

Government debt is forecast to reach 80% of GDP over the near term. While this is not out of line with other emerging markets, South Africa's low growth projections make investors question whether government bonds will remain a safe store of capital.

Our outlook for SA government bonds does not rely on economic growth outperforming expectations. Pricing in some of the most bearish sentiment we've experienced towards SA assets, the average South African bond now offers a yield of 11.5%. That yield implies that South Africa will either face a debt crisis, or inflation will be well in excess of the upper end of the Reserve Bank's target band (6.0%). Considering the metrics, we don't believe that a debt crisis is likely over 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 also has 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 11.5% today will earn inflation plus 6.0% to 6.5%, which is similar to long-term real equity returns.  The rate cutting cycle (and potential for a slightly better environment) further adds optionality of capital appreciation to the investment thesis.

Are developed market rates (at 15-year highs) the more attractive option? 

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 a strong risk appetite for these markets. 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 as well as on the currency risk.

Developed market bonds in our view offer significant risk of capital losses as key markets (the US, UK and Japan) continue to run budget deficits against significant debt maturities. The US has approximately 46% of its debt maturing in the next 4 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. In combination, these factors will put upward pressure on developed market bond yields. As unlikely as it may feel today, for local fixed income investors, we caution the impact that a reversal of the rand can have on preserving capital and your need to outpace local inflation

Multi-asset income funds offer an attractive solution in the current volatile environment

Local income funds are set up to offer attractive prospects for risk-adjusted income returns in the years ahead through a healthy exposure to government bonds with attractive real yields. We believe multi-asset income funds are well placed to provide investors with this exposure in a manner that preserves capital and manages short-term volatility while attaining sufficient yields to meet income needs.

PSG's award-winning fixed income capability

At the Raging Bull Awards hosted this year, the PSG Diversified Income Fund won Best SA Multi-Asset Income Fund for straight performance and the Raging Bull trophy for the Best South African Interest-bearing Fund over three years. The PSG Income Fund won Best SA Interest-bearing Short-term Income Fund on a risk-adjusted basis over five years. (All awards for the period ending 31 December 2022, details of awards are available from PSG Collective Investments (RF) Limited.).

*Lyle Sankar is Head of Fixed Income at PSG Asset Management.