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By Ian Scott*
South African investors are feeling saturated with bad news particularly with regard to their equity investments. What seems to get less attention is fixed income investments where the news is more positive.
So what is fixed income?
Fixed income investments, also called bonds, can be defined as debt investments or ‘IOUs’. Say a company (or the government) needs to raise money; instead of going to a bank for a loan they can offer to issue a bond to investors. Essentially they are borrowing money from investors, in return for which they promise to pay a specified amount of interest (known as the coupon or yield) over a specified period (the lifetime of the bond).
Here is an example to show how fixed income works from an investor’s point of view:
An investor buys a 10-year bond for R20 000. The bond pays a coupon (or yield, which can also be thought of as the interest rate return) of 6% per year. Therefore, each year the investor will receive R1200 (6% of R20 000) over the course of the bond term of 10 years. This coupon is usually paid semi-annually in arrears. At the bond maturity, i.e. that is when the investment period ends, the government or entity that issued the bond repays the investor the full face value that was borrowed (R20 000).
The yield, or coupon, is paid for the term and credit risk the investor takes on the bond. The yield has to be attractive for the investor to lend the money to the issuer, as not only should the investor get the full loan amount back at maturity of the bond term, but they also be compensated for the term interest rate risk taken.
Why is fixed income a worthwhile investment?
The purpose of investing is to get your money to grow by earning returns above inflation. Fixed income generally offers an above inflation and stable return profile. Bond yields are affected by short-term market movements like global sentiment and currency movements, but over the medium to long term have more stable returns due to the fixed nature of the coupons. Therefore fixed income is ideally suited to risk adverse investors who seek more certainty on investments. The biggest risk of fixed income is the chance of the issuer not being able to repay its debt or that there is a dramatic rise in interest rates.
What are the current opportunities within fixed income?
Fears are rising that the South African Reserve Bank will have to increase interest rates by more than expected. Currently the repo rate is at 7% (prime 10.5%) and consumer inflation above the upper target of 6%. Increased interest rates negatively impact costs to households. Conversely, however, they can mean that yields on fixed income investments become more favourable as the bad news is reflected in the price of the bond. Markets tend to overshoot on the pricing of bad news and this creates opportunity if reality turns out to be less bad than what is in the price of the bond.
While the average investor does not invest in bonds directly, due to the institutional nature of the bond market, they can do so through a variety of unit trusts, from low risk income funds through to multi asset balanced funds.
Currently, we see government bonds as an interesting investment opportunity in the funds we manage. Three years ago we had no government bonds in our portfolios, due to the relatively low yields of bonds then. We have seen a substantial rise in the prices of bonds over the last three years. We now believe there are selective opportunities in the bond market and we are selectively adding to our bond positions as opportunities arise.
We believe it is a good time for savers and there are opportunities in fixed income markets for investors looking for a stable form of return. Investments in fixed income makes sense particularly when economic growth is weak and the valuations of more risky asset classes seem uncertain.
- Ian Scott is head of fixed income at PSG Asset Management
