South African investors are familiar with the equity market, but fixed income investments (or bonds) tend to attract less attention. Recently equity markets have been besieged with bad news, while the bond markets have enjoyed more positive news. So why do more investors not opt for fixed income to grow their money with returns above inflation? What is the state of the bond market, and why is fixed income a worthwhile investment? The Head of Fixed Income at PSG Asset Management, Ian Scott, believes now is a good time for savers to put their money in fixed income markets. He says the opportunities are ripe for investors who are looking for a stable form of return, particularly when economic growth is weak. David O’Sullivan explores these issues with Ian.
Ian, let’s start off by painting the picture. What is fixed income?
Fixed income is actually lending people money, just like a bank, where we lend money to banks, corporates and the government. For that term that we lend money, let’s say to a bank, we want to be rewarded, we want to get an interest rate from the security for the risk that we’re taking. Remember, at the end of the term we want our money back and every three or six months we want a coupon out of that in return for lending the money. That’s basically what a fixed income is; it’s lending different entities money in the market.
So when we’re talking about the coupon, explain that in detail. It’s so often called a yield as well; can that be seen as the interest rate return?
Well, it’s basically the interest rate that you’re going to receive at different intervals, on the money that you lend. So if you lend the bank R10,000 for ten years and they pay you a ten percent coupon, they’re going to pay you R1,000 a year in different instalments, that’s basically what it is, for the life of that instrument.
What happens at bond maturity, do you get all your money back?
You get your money plus your last coupon back.
Why is this a worthwhile investment?
What we’ve seen over the last few years is what we call real yield, the yield that you earn is above inflation. Now remember for pensioners and investors, inflation is your worst enemy and what we’ve seen with the interest rate cycle that’s been hiked over the last three years is that we are starting to see higher real yields in the market. So, you’re getting a return above inflation, which is a good thing. In 2013 it was very hard to get a real yield or a return above inflation in South Africa because the repo rate was cut to five percent, and long term inflation is six percent.
Now we can find eight and eight and a half percent yields when inflation is moving from 6.5 percent last year to levels of around 5.5% in 2017 and 2018. ,So we are seeing yields above inflation for the next few years, which we think is a good opportunity for investors and savers.
Bond yields are affected by short-term market movements, like global sentiment, like currency movements; explain that in more detail.
Well, there’s obviously a short-term volatility in markets, but I think what’s quite important, if we talk about government bonds, it’s to say what is the quality of government. When we talk around South Africa there’s a lot of noise at the moment around government and government finances and government yields, but if we look at South Africa, I mean just look back at the budget last week, it’s a very solid budget and there’s little risk of default in South Africa.
So I think there’s a lot of noise in government bond markets and obviously secondly, the currency plays on bonds because the level of the currency affects the level of inflation and the market prices for it, but as the Rand strengthens we suspect that inflation could be lower down the line this year or next year, which will be a good thing for interest rates and for bond yields.
We have seen some volatility regarding the currency. How do you take a long-term view to ensure that the yields are going to be consistent?
We take a through the cycle view. For us it’s all about real yield, if we think that in South Africa inflation over the long-term is probably a six percent target and we’re getting real yields or government yields around nine percent, that’s CPI plus three and you say, ‘we’ll it’s on a government risk level plus there’s a high probability that you’ll get your money back plus there’s a high form of liquidity’, therefore we think it’s a good investment for our investors over the medium-term to longer-term. As long as we’re getting compensated for the term risk and the credit risk that we take in government bonds we think that they have a place in our portfolios at the moment.
You’ve mentioned the budget. You were satisfied then that the outlook going forward is positive for bonds.
It is positive for bonds because let’s be fair, it’s actually quite simple. The government always plays a balancing game between raising taxes or issuing more bonds. What we’ve seen with this budget is government is going to tax us all a fair amount more, but they’re not raising an excessive amount of debt, which is a good thing for the bond market, so although it’s going to hurt the man in the street, it’s actually positive for the bond market.
Should the rumours that we’re hearing become reality, and Pravin Gordhan is replaced by Brian Molefe, are you concerned about the outcome going forward if that happens?
Well, currently there are lots of political noise and a good example was what happened with Nenegate in 2015, so sure there’s going to be a market reaction, there should be, but how long it’s going to be, we don’t necessarily know. It is also quite important to understand what is already being priced in by the market, but the markets will always overreact or underreact depending on what the news is. I think we’re just looking for where we can find mispriced quality assets over the medium to longer term, not what the short-term swings and roundabouts in the markets are going to be.
Do markets tend to overshoot on the pricing on bad news?
Absolutely, as I said to you in December 2015 when Nenegate happened, you clearly saw that there was a massive overshoot in the currency, bond yields went up to 10.60, and yet today they’re trading around 8.75. We see this as typical of market behaviour. Whenever there are these risk events that happen, you can clearly see that markets overshoot on the up side and on the down side, so I think that’s just the phenomenon of markets, but that’s also where the opportunities, for the likes of ourselves, arise when there’s a lot of fear and uncertainty in the market and high quality assets get sold off in a panic, we’d like to be buyers when we find quality that goes on sale.
Is that environment prevalent at the moment?
We selectively find opportunities and we watching markets with interest, we apply our cash thoughtfully, we don’t just rush into the market, but when we see opportunities and we think that some quality assets go on sale, we apply cash. We’re not afraid to buy when we think that quality assets are just being mispriced by the market.
What other risks could impact on current opportunities?
Well, I think it’s more global, whereas in 2016 we had a lot of local risk, I think this year there’s more offshore risk. We flagged this in our Outlook roadshow that there’s obviously risk in global bond markets who have had a 30-year plus bull run and that has probably turned. We think we’ve seen an inflection point in global bond markets even before the election of Mr Trump, and you’ve seen that 10 year US bond yields rise from one and half to two and a half percent, and a rise in European bond yields because there’s political uncertainty in Europe.
We’ve seen the first shoots of growth and inflation in developed markets since the global financial crisis, so there is some negative news in the global environment for bond yields, but we don’t know that it’s necessarily having a big effect on South African bond yields. We think that SA in a more disinflationary environment. The start was probably at the end of the rate hiking cycle and we’re probably going into a more disinflationary cycle, so we think it’s a good place for South African bonds, coupled with the fact that we’re probably going to have better growth this year than we had in 2016.
Three years ago you didn’t have any government bonds in your portfolios, why was that?
Well, for us it’s simple, it’s all about real yields. We’re not relative in nature, we’re absolute. Three years ago, as I said to you, the SARB cut the repo rate to below long-term inflation and bond yields were around 6.5 percent with long-term inflation at around six percent, so we said the margin of safety was just too little in bond yields for the risk and that’s typical of our process. When we don’t find value, we don’t have a small position or a relative position, we have zero in our portfolios and when we like an asset and when we think there’s a margin of safety, we’ll have an allocation in our portfolio. Now that the ten-year bond yields are around 8.75, longer bond yields are, call it around 9.5, we think there’s a margin of safety in bonds, notwithstanding the political noise out there and we want to lock in higher real yields for our clients over the next few years.
Your portfolios comprise a diversified spread of high quality names that are offering yields at a healthy premium. Ian, can you give us some examples?
Yes, I think a good example would be the banking sector. When banks wanted to borrow money from us in 2013, they wanted to pay us, around 70 basis points over interbank rates for lending them three-year money and we thought, ‘No, that is just too little compensation for lending banks three-year money’. What we’ve seen with the change in the interest rate cycle, 2% of hikes over the last three years as well as the introduction of heightened legislation around bank capital, banks have to borrow more long term from investment managers like ourselves.
Now we’re finding that, and we’re talking to the major banks here in South Africa, for lending three-year money, they pay us interbank rates plus 1.3% and for five-year money they’re paying us interbank plus, call it 1.5%, so we’re finding a lot more opportunity in lending money to banks than we did three years ago, so we are allocating to banks at the moment.
When it comes to fixed income investments the news is more positive. You clearly are very buoyant that the markets are at a stage where we’re going to have a significant bearing on future asset price returns.
Yes, bond yields three years ago were so low and you couldn’t really derive a high real yield from fixed income assets, whereas now in terms of different areas of the curve, we think there is good opportunity. We think that the bank funding curve, or the NCD curve is another one. We can go and buy one-year NCD’s at 8.30% at the moment and inflation this year could be around 5.5%, that’s nearly CPI plus three from the cash. We couldn’t’ do that three years ago.
We talked about bonds and we think there’s a good opportunity in government bonds and then thirdly, we think there’s a good opportunity in bank and bank related credit. Three years ago these opportunities didn’t exist, so we’re quite excited about the opportunities in the South African fixed income market.
Ian, is this an opportunity that is going to be with us for some time or should people be acting on the opportunity now?
David, I think people should act on the opportunity now because as inflation falls and we believe in the latter part of 2017 and 2018, the path of inflation and rates could be lower, so we think this is a window of opportunity that exists at the moment and we think that investors and savers should use that opportunity while it’s here and we have high real yields, before yields fall away, let’s say in the next year or so.
So, it’s a good time for savers.
It is a very good time for savers, especially if you’re worrying about the risk in your portfolios. If you were just wondering; Well what do I have to do?, I think sitting on cash for the moment, you are getting paid or rewarded for just sitting out and saying, “Well, until I can make a better decision, I’m suddenly earning an eight or nine percent yield in fixed income, which I couldn’t do 3 years ago, so it’s not too bad just sitting and waiting, if you are more concerned around risks in the world at the moment.
