Category Investments

Shaken not stirred

20 September 2004 Angelo Coppola

The impact of structural changes on SA bonds to a low inflationary environment in South Africa.

The strong absolute returns of bonds as an asset class relative to equities and cash have surprised many local investment managers and investors, over the past five years, said Louis Niemand, a market and economic research economist at Investment Solutions.

“However, during this period the asset-allocation and portfolio-construction strategies of most investment managers had substantially higher exposure to equities than bonds, presumably based on the investment principle that equities outperform all other asset classes over the long term,” he said.

The question is whether this phenomenon will continue during the next five years, and does it justify an increased allocation to bonds. The answer begins with understanding what drove the strong performance of bonds during the past five years.

Since 1998, the South African monetary authorities have had an inflation-targeting policy aimed at creating price stability.

Inflation targeting has been used successfully during the past 10 years by many developed and developing countries to ensure price stability by reducing inflation and inflation volatility. This has contributed to a dramatic structural change in bond yields in almost all countries that introduced this measure.

For example, UK government bond yields declined by about 8% for the five-year period after inflation targeting was introduced. It was the same in Australia, where bond yields declined by more than 7%.

Niemand said that of significance during the past five years, is that inflation in these countries has remained within the respective policy targeted bands, moving higher or lower as the economic cycles unfolded.

During the long-term structural break to lower yields, the outperformance of fixed-interest managers was largely driven by being “long” duration -- typically the dominant contributor to performance when there is a structural decline in yields.

However, as bond yields settle into the new, narrower “trading” ranges, the trading ability and ability to assess “credit” of managers become more important elements in outperforming benchmarks.

“Also of significance, is the structural decline in SA bond yields from 15% to 10% noted in the last five years coincided with inflation targeting in South Africa, mirroring what occurred in two global examples above,” he said.

Niemand believes now that inflation, at least for the past 11 months, has settled within the SARB's target range, expectations are for it to remain within the 3% to 6% band for the foreseeable future.

“As inflation volatility and expectations decline further, so is the volatility of the local interest-rate environment expected to follow suit. This implies South African bond yields could follow a very similar pattern to the global examples, ie SA bond yields trading within a narrower range.”

He said that global inflation and interest-rate trends, and obviously the Rand, will have a significant influence on this outcome.

“The initial rise in local yields marked the end of last year's easing cycle in local interest rates.

"Despite concerns about the near-term outlook for local inflation and the decline in interest rates due to continued Rand strength and muted food prices, the anticipation and start of the US's tightening interest-rate cycle caused global yields to rise aggressively in the second quarter.

"The SA bond market was not immune to the more than 1% increase in US bond yields. The battle between the more positive structural forces (long term) and the more negative cyclical forces (short term) will continue to drive bond yields during the balance of the year, in a relatively narrow trading band,” he explained.

“As such, SA bond yields are expected to be range bound for some time, with managers needing to “sweat out” outperformance of the ALBI, utilising all areas - credit, duration and trading,” Niemand said.

“The short-term (one to two years) outlook and return expectation for bonds remains muted, but provided inflation remains under tight control (locally and globally), the longer-term bullish trend for bonds should remain intact,” concluded Niemand.

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