Hitting bottom … but don’t rule out a bond rebound, says Mphaphuli

Bonds are currently the pariahs of our investment market. They’ve been out of favour for more than two years. Every fund manager currently underweights them and expects under-performance compared to other asset classes for months to come.

STANLIB’s award-winning ‘bond king’ Victor Mphaphuli should be out on his feet by now. Instead, he looks more like Rocky Balboa – a little bloodied, but capable of pulling off some surprises in the next few rounds.

In March, he was appointed head of bond and income funds at STANLIB, South Africa’s largest unit trust company and the country’s most successful fund manager. A couple of months later he and his team took the crown as the top manager in his chosen field at the Morningstar Awards for best risk-adjusted returns.

He and his team won four accolades over one, three and five years in the bond and income fund categories.

There was no such consolation for bonds. The market remains depressed.

Bonds have an inverse relationship with interest rates. As rates rise, capital values in the bond market fall. If the fixed coupon on your bonds is significantly lower than the money market rate, why not move into cash?

As sell orders rise, a bond’s asking price in the secondary market falls.

Mphaphuli explains: “It’s not quite right to say bonds react only when rates rise. Bonds don’t wait for official announcements, they anticipate them. This market moves on expectations and adjusts as new information comes in.

“Despite the market’s sensitivity, history shows that when a change in the cycle occurs, it almost invariably comes as a surprise – sometimes a big one.”

The certainty of eventual recovery explains Mphaphuli’s continued resilience, but he admits there is no sign of a rebound just yet until the market senses a turn in fundamental variables e.g. inflation toping out at some point, which may not be too far away.

He joined the investment industry as a trainee currency trader in 1996 with Standard Bank treasury, but soon moved into bonds and was a bond trader at Liberty Asset Management in 2001 when the bond market was also going through a long bullish run following the 1998 market volatility.

When the change came, bonds moved from zero to hero in a matter of weeks. However, bonds are currently at an historical low.

“Even during periods of pressure, most balanced funds traditionally had a bond allocation close to 20%,” says Mphaphuli. “Today, it’s down to 10% on average, with more aggressive managers even as low as 3%.”

Recent returns explain the aversion.

In the year to the end of May, the All Bond Index was down 5.0%. On a 12-month rolling basis, bonds had lost 3%. In the month of May alone, a 2.5% retreat was charted.

In contrast, there was a 10.3% return on cash for the year to the end of May. Do figures like this suggest a further stampede out of bonds?

Mphaphuli doesn’t think so.

“At current levels, big moves out of bonds into the money market might be risky,” he says. “Strategists have probably gone as low as they would want to go. You can get out, but you might not get back in.

“When the market turns, the likelihood is that every fund manager will try to increase bond allocations at the same time. Capacity constraints would then become pronounced; leaving you locked out at a time when significant profits might be made.”

So, no big sell-off is in sight at current levels, but there’s also no sign of rising demand either. After all, inflation and rates are expected to remain high for some time.

In the interim, Mphaphuli and team are focused on variations in the yield curve – a line that traces interest rates or the cost of borrowing against the time to debt maturity.

The longer out you look, the bigger the losses tend to be in a rising interest rate environment. Astute bond managers that anticipated this trend have beefed up their holdings of bonds with maturities in the short to middle sectors of the yield curve and an underweight in the ultra long maturities.

“We have been able to limit the rate of loss through allocations into shorter to medium-dated bonds,” says Mphaphuli. “The overall All Bond Index average is down just over 5% year to date, but the loss on bonds with maturities over 12 years is 11.6%, compared to a combined loss of -2.5% for maturities between 1 and 12 years. So, a conservative approach on the yield curve had a higher pay-off.

“When the cycle turns, the biggest gains will probably be made on the longer-dated issues, but for the present the challenge is to maintain a balance while optimising every opportunity along the curve.”

Others may shun the bond market, but Mphaphuli is around for the long haul.

“Whether you’re in favour or out of favour, your responsibility is the same,” he notes. “You have to optimise the opportunities every day. There are no twenty dollar bills lying on the street.”

It also helps when you know your day will come…