This undictated podcast is brought to you by Futuregrowth Asset Management. Hi, this is Candice Paine. I’m sitting with Wikus Furstenburg. He’s a Fixed Interest Portfolio Manager with Futuregrowth Asset Management and today, we’re just going to talk a little bit around the outlook for the South African bond market: where we’ve come from, where we’re going, and some of the risks that we’re looking at going forward into 2015.
Yes, Candice. I think that if I look back, I want to think about the last 12 months to the end of March this year actually had a good year for bonds. As we know, globally yields surprised most. If you go back to the beginning of 2014, a lot of analysts and so-called commentators that U.S. bond yields are only going to go up because the Fed is probably going to start tightening policy at some point. In a similar vein, on the local sides there were concerns earlier in terms of sustained currency depreciation and the impact of that on future inflation. Of course, January was one of the big months for us where the Index did very well. We gave back about 50 percent of that performance in the consecutive two months but still, if you look at the total picture, bonds did really well. It outperformed cash handsomely. It did much better than inflation and even nominal bonds did better than inflationary bonds over the last few months. You didn’t want to hold inflationary bonds from the end of May last year until round about the end of February of this year, simply because inflation surprised on the downside and partly because of much lower oil prices.
Wikus, let’s just talk about that real return that you can get from bonds, which is obviously what an investor is after. They’re wanting to outperform inflation. What we’ve seen is that you’ve actually had superior real returns from bonds over the last couple of years. Why is that and what can investors expect going forward, given that the inflation expectation is probably lower and that may mean that interest rates don’t rise as quickly as the expectation was?
Over the last few years (and we say ‘last few years’ I think we need to go back to 2008), we all know what happened since then. The globe battled with sub-trend growth and the globe also had to face inflation. In some cases, fear, and even evidence of negative inflation. As a result, you’ve seen bond yields going much, much lower than many thought possible – not only in developed markets but also in some of the emerging markets. There’s been a lot of capital appreciation that came through on the back of that. In a way, one has to be really wary of being too focused on historical returns. It’s done very well but planet Earth really had to battle with these things that we’ve mentioned. In my mind – going forward – don’t expect and don’t extrapolate the same sort of real returns we’ve seen over the last few years. Expect lower returns. Expect lower real returns and expect more volatility because yields are low. Even in Europe, you’ve seen that some of the bond yields are trading at close to negative levels. That’s not sustainable. It’s there because of Quantitative Easing and at some point, you’re going to see some normalisation coming through, and you should remain focused on that.
What does that normalisation mean for the average investors? If they need to be managing their expectations down in terms of absolute return that they’re going to get going forward, how do they view bonds in terms of a total portfolio or as a standalone investment, if that’s where their income has actually been coming from in the past?
You need to focus on two things. Total return in the space obviously consists of (as you mentioned) income. Then of course, possible capital appreciation. If bond yields fall, the price of that bond will go up and you will gain, and that gives you a total return which, like the last few years, actually surprised on the upside. For an investor who’s focused on income, the bond market will always be the place to be because you will receive your income. That bond will pay a coupon every six or every three months, unless the Issuer or in this case, the Borrower, defaults – for example, African Bank. Usually, Borrowers in South Africa are really quite good. They tend not to default on their debt and with one or two exceptions, have done very well over time, so clients should really be focused on that. Then, don’t bank too much on that capital appreciation.
Okay, so some of the risks that the investor faces is obviously interest rate risk and credit risk. There are also a whole bunch of idiosyncratic risks for the South African investor in the South African bond market. Some of the things that would be foremost in people’s minds are things like Eskom, the Rand, and the rating of our debt from an international point of view. Can you touch on some of those also and how you view that in the context of your portfolios?
Firstly, Eskom as standalone entity: we know all the problems. Even my 12-year old knows about that, so there’s not much value that I can add in talking too much about Eskom. From an investment perspective, the bonds that are issued by Eskom carries an explicit Government guarantee.
That’s good to know then, from an investor’s point of view. It’s not another Abil.
It’s not another African Bank. The risk of default obviously sits with central Government so if you have a view that central Government’s going to default, then of course, there’s a different issue. That’s the way we look at that. However, it is clearly still necessary for Eskom bonds to trade at a discount, relative to Government bonds because it’s just a different Issuer. They have their own issues but I think that in terms of default, one shouldn’t worry too much about that. In fact, I think you can make a case to add exposure to Eskom bonds over time because it has cheapened. It’s cheaper to go out and buy Eskom bonds at this point. You’re still going to get your income. They’re going to pay that coupon every six months.
When you say it’s cheaper, it means that there is potential for capital gain, when that value unlocks.
Well, that’s one thing. That’s a possibility but again, in this environment, we don’t focus too much on that. The point here is simply that the yield has gone up, the price has come down, and we get more for our bucks. I think that’s the focus. In terms of credit ratings: with all due respect, credit rating agencies tend to be backward-looking. A lot of the bad news in terms of South Africa as a sovereign and in terms of Eskom and some of the other state-owned enterprises like Sanral for instance, is in the price. I think that they’re just confirming, by decreasing the credit rating, as they did over the last little while. Going forward, we’re comfortable that South Africa’s sovereign credit rating will not be downgraded soon. For now, we’re doing enough to avoid South Africa’s credit rating going to sub-investment, and that’s how we currently position our funds as well. There are a number of reasons for that. It’s not the only reason, but the most important one is the fact that National Treasury is really working hard on trying to reduce the Budget Deficit. Good news of late was the fact that tax revenue actually surprised on the upside and that was because of even better compliance, and that’s good. The reason for that improvement is good news.
Okay. Just before we wrap up, can we just talk a little bit around the influence that foreign investment flows have on our bond market? Obviously, foreigners are after the yield that South Africa can give them. You spoke about volatility and volatility going forward. What does that mean for your bond portfolios?
Firstly, we need to have a feel for the size of the exposure in the local market. According to National Treasury, it’s close to 40 percent of total local currency debt. That’s big. Obviously, that’s linked to South Africa’s inclusion in foreign currency indices such as City Group and a few others that we can mention. A lot of that is passive management as well, but there is active management so if something happens that makes them uncomfortable, a 40 percent holding will make a difference. If they start selling, bond yields will have to respond. It will go up. There’s no doubt about that. It’s as simple as that, so it adds to the risk of volatility. At the same time though, it’s good to have more participants in the market because it improves liquidity and you always want people on both sides (Buyers and Sellers) to improve price discoveries. There’s a downside to it, but there are obvious benefits to foreign participation in the local market as well. I think it’s also important to mention that their participation is different to what it used to be a few years ago. It was very opportunistic a few years ago (in/out). Sometimes, it caused silly moves. It didn’t really add any value. The majority of those investors now are probably more medium/long-term investors and that adds some stability to debt presence.
Okay, and that’s also good news – that they’re taking a long-term view on South African debt.
That’s true, but it can also change quickly and that’s the problem.
Wikus, thanks so much for your fascinating insights into the South African bond market. I’ve been speaking to Wikus Furstenburg who is a Portfolio Manager with Futuregrowth Asset Management. This undictated podcast is brought to you by Futuregrowth Asset Management.
