The 007 of portfolio construction
It is impossible to imagine a world of fixed income portfolio construction without there being a wide range of bond ‘building blocks’ to choose from. The 2022 Glacier Life Investment Summit raised the importance of long duration government bonds as underlying components in life annuities before offering its mostly intermediary audience a useful ‘A to Z of Bonds’ refresher. The presentation, expertly delivered by Melanie Stockigt, a Portfolio Manager at Laurium Capital, shared some key principles of the bond product universe before delving into technical aspects of these popular financial instruments.
The IFAs chance to play banker
Stockigt chose to introduce the topic by comparing bonds to equities, but we prefer a simpler Investopedia.com definition to start. The website defines a bond as “a fixed-income instrument that represents a loan made by an investor to a borrower, or an IOU between the lender and borrower that includes the details of the loan and its payments”.
Some of the important characteristics of a bond include that it pays a coupon or predefined series of payments to the lender; that it offers a fixed maturity date upon which the lender receives the principal amount; and that it gives the lender [or investor] a preferential claim on cash flows. “Every bond that you encounter will have three characteristics: it will have a coupon type, an issuer and a fixed maturity date,” Stockigt said, before unpacking each of these characteristics in greater detail.
The coupon types carried by bonds listed on the JSE include fixed-rate, inflation-linked and floating rate notes among others, with the first-mentioned making up around 70% of the issuance in the SA market. “The lion’s share of bond issuance in the SA market takes the form of fixed-rate bonds, followed by inflation-linked bonds,” explained Stockigt, before observing that many corporate bonds were issued with floating rate notes. Most local bonds are issued by government, which is the dominant issuer accounting for around 76% of the market. Other large issuers include state-owned enterprises, municipalities and banks. Corporate bonds, described as bonds issued by non-government entities, are popular too, allowing large local firms to raise capital in the bond markets.
Basics features of fixed-rate bonds
Since fixed-rate bonds make up the bulk of the market, it seems fair to place this product under the microscope. A fixed-rate bond offers a predefined series of cash flows that are fixed over time. Assuming you invest R100 into a 10-year duration fixed-rate bond with a 10% annual coupon, the bond will pay you a R10 coupon payment each year. Upon maturity you will receive your final R10 coupon payment plus your R100 principal. Income fund managers favour bonds because of the certainty of cash flows over the duration of the investment, which make it easier to model.
It turns out that the only variable in the fixed-rate bond equation is the so-called market rate which is used to calculate the present value of the future coupon payments. Stockigt pointed out that the market rate “moves all over the place” for the period of the bond investment whereas “the cash flows on the bond stay fixed”. The inverse relationship between the bond price and its yield, not to be confused with its coupon, is something that often trips up the lay investor. We have paraphrased liberally from the presentation to explain. The price of a bond, which is the amount you could ‘sell’ it for if you decided to exit it before it matures, is linked to the market rate or yield. In a nutshell: as market rates move up, the price of your bond moves down; and as market rates move down, the price of your bond increases.
Using the previous example, when you invest in a bond that pays a 10% coupon rate you are locking in a cash flow stream of 10% on the principal. If market rates increase to 12%, then the 10% cash flow attached to your bond is less attractive and the price of your bond will fall. The opposite holds too: if you are earning 10% on your fixed rate bond and market rates move down to 8%, then the cash flow from your 10% coupon are more valuable relative to the market, and the price of your bond will increase.
The triple-R bond valuation model
With some of the basics handled, Stockigt turned the audience’s attention to the various factors that influence market rates, and therefore bond prices. The asset manager employs a simple bond valuation framework based on three Rs, namely the risk-free rate; relative inflation and the domestic cycle; and risk premium. “We have always used the US 10-year Treasury as our benchmark or risk-free rate; we think of this instrument as the financial sun that the rest of the global bond universe moves around,” she said. Fund managers must make allowances for a range of factors, most notably the different inflation dynamics, when valuing locally issued bonds.
The second part of the valuation exercise is aimed at determining the additional yield that investors expect in return for investing under local inflationary conditions relative to those in the US. “This is driven by where we are in the domestic growth cycle, how inflation dynamics are changing and how the South African Reserve Bank (SARB) sets interest rates in response to macroeconomic factors,” said Stockigt. The third R represents the further adjustment to the bond valuation to compensate for the risk of default by the bond issuer. Although government debt defaults are rare they do happen, and the South African government presents greater default risk than the US government and many other countries.
Much of the remainder of the presentation was dedicated to unpacking global and SA inflation dynamics as financial markets power into the second quarter of 2022. Inflation is top of mind among asset managers as the world emerges from two years of pandemic with much of the developed world fighting the effect of higher prices for goods and services. Rampant inflation is being blamed on the fiscal and monetary policy interventions made by the US and other Western economies to assist businesses and citizens during 24 months of pandemic and lockdown, coupled with consequent constraints to global supply chains.
Pandemic and war: a perfect storm for inflation
“More recently, we have seen the Russia-Ukraine situation which is having a huge impact on oil and food prices; on top of already high inflation, we are seeing another inflation surge,” noted Stockigt. “As inflation fears have been increasing, bond yields have been rising to compensate investors for this higher inflation outlook”. It looks certain that bond yields will continue to rise through 2022, because most central banks have no choice but to embark on aggressive interest rate hiking cycles. The US is a case in point, with early expectations of three or four 25 basis point hikes this year making way for forecasts of seven.
South Africa’s inflation is currently at around 6%, and the SARB has already hiked interest rates three times in this hiking cycle. Income fund managers are now nervously watching for signals from the SARB as to how aggressively it will hike the repo rate through the remainder of this year. “If policymakers expect all of the recent price shocks to oil and food to push us to six or seven per cent inflation, then the SARB will have to respond a lot more aggressively,” concluded Stockigt.
“We also have to have keep an eye on global developments; if the US Fed hikes rates aggressively, and this leads to ‘risk off’ globally, capital outflows from emerging markets could contribute to substantial rand weakness and force the SARB’s hand”.
Writer’s thoughts:
Today’s newsletter hardly scratches the surface of the complex and technical bond universe. For example, it does not delve into yield curves or inverse yield curves let along explain what these curves can teach us about the economic underpins; but at least we covered some of the basics. Do you give much thought to the valuation of bonds in your client’s portfolio, or do you leave such concerns to the fixed income experts? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts editor@fanews.co.za.
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