How fixed income investors should manage downside risks while targeting high real yields

Ané Craig

While 2025 looks set to be quite eventful, the promising news for South African investors is that local fixed income markets seem poised to deliver another year of good real returns.

Although we expect investors to benefit from continued positive market dynamics locally, we also anticipate volatile returns over the year given an unpredictable global backdrop and heightened sensitivity to news flow. Risk management will therefore be key – but an over-reliance on volatility indicators in isolation could be misleading.

Last year was a bumper year for bond returns, with the FTSE/JSE All Bond Index (ALBI) delivering 17.3%. With CPI averaging 4.4% for 2024, it means that bond investors saw a 12.9% real return for the year, well in excess of the asset class’s long-term average real return of between 2% and 3% p.a.

Bond markets can be surprisingly volatile
While bonds are considered to be less risky than equities in the long run, this does not mean that they are exempt from volatility in the short term. The CBOE Volatility (VIX) Index is often cited as an important indicator of ‘fear’ (or sentiment) in equity markets. It measures the market’s expected 30-day future volatility by analysing the prices of S&P 500 Index call and put options. Bond markets have their own metric called the Merrill Lynch Option Volatility Estimate (MOVE) Index, and although it is less well-known than the equity market equivalent, it provides an indication of expected volatility in the US bond market. It should be clear that bond markets can be as susceptible to bouts of volatility as equity markets.

Volatility indices: Stocks and bonds

Sources: PSG Asset Management and Bloomberg

For this reason, many income investors equate managing risk within their portfolios with keeping volatility as low as possible. Investors into well-diversified, professionally managed income funds should rightfully expect a smoother return profile than what is available in the bond market itself. However, there are dangers to constructing an investment portfolio with low volatility as the primary goal, or using volatility as the key indicator of risk in a fixed income portfolio.

Instruments that don’t mark to market have enjoyed a popularity boom
In recent years, we have seen a rise in the use of instruments that do not mark to market in fixed income portfolios. These include private debt instruments, and credit-linked and structured notes. In many cases, these instruments offer an enticing yield, but undoubtedly a large part of their attraction lies in the ‘less volatile’ return profile they contribute to portfolios. Consequently, credit-linked notes (CLNs) and structured notes have grown in popularity over the last few years, reaching R60bn in issuance in 2024.

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