Rare opportunity to smash inflation with yield

*This content is brought to you by Brenthurst Wealth

By Brian Butchart*

In investing, there are two types of risk:

1. Loss of invested money
2. Loss of purchasing power (or inflation)

Investors who are looking for good interest/yield on their investments, usually have the same basic requirement: beat inflation. Investments should enable the investor to increase purchasing power. Inflation means today’s R100 can buy more goods today than that same R100 can buy next year. To grow wealth, means putting that R100 into an investment that delivers a return higher than inflation.

The below meme hits the nail on the head – money loses value over time.

Return and risk (greed vs fear)

Investors take on risk when they buy investments and require “compensation” for that risk. Higher risk investments (like equity – think your typical listed company like Naspers or Sasol) require higher returns from investors. When the market is trading normally, higher returns are only possible by taking on more risk. To achieve inflation beating returns, an investor usually needs to have some equity exposure, but there may be a rare opportunity in the local bond market, that can deliver inflation beating returns (while not carrying those equity levels of risk in a portfolio).

For those of us less familiar with bonds, they are the opposite of taking out a loan. We, the investors, give the Government our “loan” amount and in turn receive monthly “coupons” or interest payments from the Government. These loans to the SA Government come with a Guarantee that the SA Government will repay you.

But bonds are a little more complicated than just that… As a quick example, if a bond pays you a R100 Coupon, while the Bond trades at R1,000 the yield would be R100 / R1,000 = 10% When the interest rate (Repo Rate) goes up, bond yields will adjust accordingly and increase to keep pace with the higher Repo Rate. The increased yield, while the coupon remains unchanged, requires a decrease in the price of the bond. Recently bond yields have increased substantially in anticipation of much higher future Inflation, causing bond prices to fall to attractive levels for new investors to buy in. This is why they say bonds are “forward looking” as they price in the future or expected Inflation figures.

A big opportunity

We have seen a significant increase in US inflation over recent months, largely due to stimulus measures that flushed the economy with excess cash. Its aim was to support the economy during Covid lockdowns, but it was arguably overdone, and the result is very high inflation. An oil supply shortage adds fuel to the fire. To fight the inflation trend, the Fed and other central banks (including SA Reserve Bank) are raising interest rates, and mostly playing catch up with by implementing a fast pace of rate hikes. If you have a home loan, you will probably start to feel the pinch of higher interest rates, but if you are a potential investor with cash, you are holding all the cards.

The South African Reserve Bank recently increased the repo rate to 6.25% (linked bank prime rate 9.75%). An investor looking for low risk cash-like exposure can invest in a Money Market fund. You may earn a yield of up to 6.2%, but this will result in a loss of purchasing power since the current SA Inflation (CPI) rate is 7.6% (you need to be earning a similar return to retain your purchasing power).

The South African 10-year Government bond (R2032) yield is ~11.2% and has opened a significant gap to Money Market rates which are at 6.2% (that’s a 5% premium for R2032 holders!). Rarely in the past have we seen this magnitude of a disconnect between short term rates and long-term bond yields.

This unique opportunity to acquire bond exposure at these yields does not happen often. Inflation is expected to gradually decline to below 5.0% over the medium term and if you buy the current 11.2% yields, you are looking at 6%+ real yield (income yield after accounting for inflation).

Looking at the figure below, you’ll notice that rapid increases in bond yields does not occur often. The past ~20-year period only delivered three opportunities to acquire bonds at abnormally high or attractive yields. Could we be in the midst of another opportunity?

It is worth pointing out that not all investors have the same risk appetite or risk “budget”. Some investors are more comfortable with the additional risk, measured using volatility, being greedy adds. Looking at the risk of bonds versus Money Market shows very clearly the amount of risk being added but could this be the only two options? Of course not. The ASISA South African Multi Asset Income category (Income Funds) aims to service this need. Income Funds carry slightly more risk than Money Market funds due to the inclusion of some bonds in combination with Money Market instruments, providing a very attractive enhanced yield as well as potentially some capital appreciation at an acceptable level of risk. (See Table below)

What could a grey listing mean

Insights from an IMF research paper on the topic indicates a “typical” type of reaction should there ever be something such as “grey listing”. The papers led us to believe that a grey listing will result in an initial knee jerk reaction of higher yields in the bond market and later a normalisation. The SA bond market does, however, look to have priced in a fair amount of market risk including a potential “grey listing”. Should grey listing occur, a country’s GDP does take a knock. However, in the current market situation, South Africa is grouped with an already incredibly volatile BRICS community.

The solution

When the economic outlook is uncertain, market analysts and economists need to update their expectations of future interest rates regularly as the news flow changes. This naturally creates some volatility in bonds as bond prices take their direction from changes in interest rates. Income fund managers have the necessary skills to extract attractive yields from bonds while reducing the impact interest rate changes could have on the portfolio. While no investment can ever be as safe as cash/money market instruments, an income fund does provide a competitive alternative that could help you beat inflation while not making your portfolio vulnerable to volatility.

Investment Professionals can add even more value through what is often referred to as the only “free lunch in investments”, namely diversification. Carefully selecting different income funds to create an Income Blend, provides the investor with stability as well as an attractive yield by blending the best aspects of the money and bond market, managed by selected managers who have proven themselves superior in this category.

Unlike in the case of simple money market funds, there are many moving parts within income funds, and it is our view after thorough research a combination of well-managed, complimentary income funds will provide a higher yield at lower volatility than the average income fund manager.

• Brian Butchart, CFP® professional, is the Managing Director of Brenthurst Wealth. [email protected]

Read also:

• Inflation – the best benchmark for portfolio performance
• Cash/money market investments and the lurking inflation monster
• Inflation-busting investment strategies