Should you have bonds in your portfolio?

Bonds are boring, or so the saying goes. A better interpretation is that bond returns are less volatile than equity returns, most of the time.

 “This is positive for investors who value stability, such as retirees. It is negative for investors with long time horizons since higher risk investments, such as equities, typically outperform over long time periods,” says Mark Dunley-Owen, portfolio manager at Allan Gray, explaining that R1 in 2000 would be worth R10.65 today if it had been invested in the FTSE/JSE All Share Index (ALSI) versus R5.67 in the JSE All Bond Index (ALBI).

Boring or not, the diversification benefits of bonds make them relevant to many investors as they tend to perform well when equities perform poorly, and vice versa.

“It is prudent to maintain some bond exposure within diversified investment portfolios, and vary this according to your objectives and your view on relative risk and return,” he notes. 

Dunley-Owen elaborates on how Allan Gray manages fixed-income: 

“We believe investment skills are asset class independent. The fixed-income investment team forms part of the broader investment team, with the same analysts covering equities and bonds. In addition, the same investment philosophy and process is applied across asset classes. We do fundamental research to determine the fair value of an asset, using sustainable cash flow as a core input. We buy when the price is below this fair value, and sell when the opposite is true. This applies to both equities and bonds. We also target long-term absolute returns,” explains Dunley-Owen.

This thinking has helped Allan Gray deliver attractive risk-adjusted returns for its clients.

“Adjusting returns for risk is important if one believes, like we do, that the last few decades have been unusually good to bond investors. The benefits of lower risk are often overlooked during bull markets only to become apparent when markets turn.”

And what does he make of the current investment climate for bonds?

“We caution against making broad assumptions about the future, such as macroeconomic forecasts, as these are seldom correct or indicative of investment performance.  Instead, we spend our time thinking about key variables that we believe will impact long-term bond returns: long-term inflation and the real return required to make South African bonds attractive to investors.”

He says that SA’s inflation has remained remarkably stable over the last 20 years, moving between 4% and 8%, but with global inflation set to increase, this will place upward pressure on inflation at home as many of South Africa’s costs are imported.

Dunley-Owen notes that the required real return from bonds is difficult to predict and there appears to be a dichotomy between the real return investors are expecting from SA bonds and the underlying risks they are exposed to.

“With the government bond yield at 2.6% as of end of March, it seems that investors are more comfortable about South African risks today relative to history. This is surprising, given the recent downgrade to junk status, as well as the country’s underlying fundamentals,” says Dunley-Owen.

A possible explanation, according to Dunley-Owen, is that investors appear to be looking forward to improved fundamentals.

“While a cyclical recovery may have seemed likely earlier this year, recent events have changed this. With our focus on long-term absolute returns, we find it difficult to forecast improvements to the fundamentals necessary to justify current real returns.”

While there appears to be upside risks to the country’s long-term inflation and real yields, he suggests investors approach bonds with caution.

“We believe there are upside risks to South Africa’s long-term inflation and real yields. In some scenarios a correction in one may negatively impact the other. For example, the government has three broad ways to reduce its debt to GDP – higher growth, austerity or inflation. Higher growth and austerity would be positive for bonds but are difficult to implement within South Africa’s socio-economic realities. Inflation is likely to be at least part of the solution. This would be negative not only for bonds, but also for the currency and South Africa’s long-term competitiveness, which could in turn force investors to require a higher real return from South Africa’s bonds. If we are right, future bond returns are likely to be disappointing.”