In uncharted territory

Melville du Plessis, portfolio manager at Sanlam Investment Management.

The world is currently in uncharted territory, as many keep highlighting. But this will always be the case as we move forward through time. The fiscal and monetary policy responses to the 2007 to 2008 global financial crisis were on an unprecedented scale – with fiscal stimulus and budget deficits leading to an increase in debt levels worldwide. On the other hand interest rates are still at their lowest levels in history and quantitative easing policies have led to massive expansions of central bank balance sheets. However, there seems to be no comparable response to the “Geopolitical Recession” the world is currently in.

One of the challenges investors are facing is extraordinary global debt dynamics. Let’s explore this phenomenon a bit further.

An exceptional bull run in bonds

Global bond yields have been grinding lower for the last 35 years. It has been one of the longest bull runs in history with total returns from global bonds over the last few decades comparable to equity market returns – and at times even beating them for extended periods. The returns investors have seen in global developed market bonds cannot be expected again. And with interest rates at such low levels it is difficult to see how this will turn out to be a good investment years ahead.

Many have even questioned whether a bond bubble is looming as a result of central bank policies as well as their associated effects and unintended consequences: low interest rate policies may have spilled over into other asset classes leading to overinflated prices elsewhere. We have reached a point in history where some debt instruments even carry negative interest rates. This is counterintuitive: you actually have to pay someone to lend them money! During the last few years the amount of negative yielding debt increased significantly with the total amount peaking at around $13 trillion during the second half of 2016. It is a staggering amount and the thought of negative yielding securities on this scale was previously inconceivable by many.

Actually, negative interest rates are not new

But the concept of negative interest rates is not a new one and dates back almost a century – also referred to as demurrage – with Silvio Gesell credited as being the original advocate. The method of implementing negative interest rates was rather novel. Taking a look first at “normal” interest bearing notes: an investor who historically bought these bonds or notes would receive a physical certificate with a series of coupons. To receive interest payments one would periodically clip off a physical coupon from the certificate and redeem it for the interest payment. In fact, the word “coupon” originates from a French word which means to “cut off”.

Negative nominal interest rates were implemented along similar lines, but with one change: the notes needed to be stamped. One would thus have to purchase a stamp at regular intervals in order to retain the value of the note: paying to hold the physical notes results in a tax on holding currency. Failure to have the note periodically stamped would render it void and worthless.

Example of Schilling note with demurrage and stamps from the 1930s

Source: Prescient Securities; Wikipedia

Two important changes over the last hundred years or so is the development of the global economy, and technological progress. The implementation of negative interest rates is now possible on a scale which was previously unimaginable. The vast amount of negative yielding debt outstanding is testament to advances and developments which enable previously identified concepts on a much grander scale. We have crossed the zero lower bound on interest rates and the use of new policy options are redefining the boundaries.

One would think that all our modern tools and developments would have been better able to assist us to understand and solve some of the current geopolitical frictions, financial market dynamics and economic challenges we are faced with. But the world is an increasingly complicated place. To make some sense of the debt and yield dynamics requires an understanding of macroeconomics, financial markets, regulatory trends and policy making frameworks.

How does SIM value bonds in these uncharted waters?

A good starting point is to look for investment opportunities that offer a good margin of safety, and keep a close eye on valuations and fundamentals as they change. It’s important to make a distinction between local and international bond valuations.

As is often the case in South Africa, our bond market runs counter-cyclical to most developed bond markets. In fact, SA long bonds are still offering among the highest local currency real yields in emerging markets. Sanlam Investment Management (SIM) is therefore overweight SA long bonds, as reflected in our flagship multi asset fund, the SIM Balanced Fund. Even if inflation settles at the top end of the 3% to 6% inflation target, a real return of 3% is on offer. This is particularly attractive given the low real returns available in equity markets, as well as global bond markets.

As far as SA inflation-linked bonds (ILBs) are concerned, the SA government is in effect in control of the rand printing press so the default risk on rand-denominated ILBs is low, as long as the inflation-linked component of the SA government’s total debt stays at a reasonably low level. Currently it is at 24%. There is probably more risk with the accuracy of the measurement and the measurement methodology of inflation, especially during periods of very high inflation or hyper-inflation. If this is a problem, then the inflation adjustment applied to these bonds would be compromised. We therefore still prefer SA conventional bonds to ILBs as is reflected in the position sizes of the SIM Balanced Fund.

Moving on to international bonds, even though global sovereign bond yields weakened after the election of Trump as president, we are keeping our underweight position. At a yield of about 2.4%, US long bonds offer a positive real return relative to our long-run inflation assumption of 2% for the developed world. We are concerned about long-run global inflation and would require an attractive premium above 2% before investing in developed market bonds.