Risky Business: SA Bond market poses more investment risk than you think

With developed world bond yields currently looking unattractive, emerging market bonds are increasingly more in demand from foreign investors. However investors should be aware that the bond market is not as low risk as it might once have been. This is ac

“When it comes to life stage investing, investors have traditionally been advised to invest more heavily in bonds the closer they get to retirement,” says du Plessis about the perception of bonds being a low risk asset. ‘However, looking at the current market, there are a number of factors which mean there are large risks in holding fast to this philosophy, particularly in a negative real interest rate environment and with people living longer.”

Accommodative monetary policy has led to negative real interest rates in South Africa and the economy is depending on portfolio flows to fund the current account deficit. According to du Plessis, this is a dangerous position for bond investors to be in should foreign investors decide to become sellers instead.

He says that a combination of factors has contributed to the state of the global bond market and the attractiveness of emerging market bonds. “Central banks continue to affect the market by buying up bonds in developed markets, to influence investment in in higher risk assets such as equities and stimulate the economy,” explains du Plessis. “Their policy of quantitative easing is, of course, also keeping global interest rates low.

“While the South African Reserve Bank has not had to interfere through quantitative easing as the Central Banks of the developed world have, our bond market still benefitted as a result of the contagion with developed markets,” he says. “The reason for this is that our market moves in correlation with global bond markets due to its high liquidity, which encourages massive foreign bond flows into our local market.”

Du Plessis points out that other factors, specific to South Africa’s economic and political landscape, could also put pressure on our bond market. “Currently, all-time yield lows within developed markets mean that SA bonds are still in great demand from foreign investors. However, our fragile political environment could lead to foreign investment losing faith in its stability,” he says. “This would be a huge knock for South African bonds.”

Du Plessis also believes that low interest rates could put pressure on South Africa’s inflation levels, which in turn could lead to a further weakened rand. “This scenario also poses more risk to our bond market, as well as the fact that offshore bond’s yields could rebound if their Central Banks step back, thereby making our bond market less attractive,” he says. “All of these factors need to be taken into consideration when looking at the current position of local bonds.”

In comparison to global bonds, the equity risk premium, which looks at earnings yield compared to bond yields, is almost at an all-time high, while bonds are not offering the kind of value that would compensate for its risk levels. This is illustrated in the chart below:

At the same time the cost of protecting equity from downside is at 20 year lows. As demonstrated below:

There is an opportunity to switch out of bond exposure and invest in protected equity. The traditional model says that you shouldn’t own equities if you are going to need to draw from capital but this is not true for protected equity where there is no downside.

According to du Plessis, considering the current investment environment, it makes sense to invest in the protected equities market. “In a world of negative real interest rates and heightened risks to the bond markets, it would be practical to adopt a more risk-focused strategy and concentrate on generating real returns while avoiding duration risk”.