LYLE SANKAR: The silver lining for fixed-income investors

Fixed-income investors find themselves confronting three key factors that are complicating decision-making in the current environment:

• Money market rates are at a high, but with falling inflation it seems unlikely that these will be maintained indefinitely.
• Many consider longer-dated government bonds as a risky choice and are hesitant to invest further out along the yield curve.
• With so much uncertainty locally, some investors are tempted to rather try to take advantage of high yields offshore. 

However, we believe patient fixed income investors can be well rewarded even in this uncertain macro environment, with the ability to lock in the prevailing high yields and achieve inflation-beating returns.

With bond yields pricing in a degree of negative news, investors will need to focus on the most important aspects that will drive returns to enjoy the benefits of the yield environment. 

Money market returns are likely to moderate in the future 

Money market rates have played their role to perfection as a safe capital store, offering progressively higher yields during the SA Reserve Bank’s aggressive rate hiking cycle. But investors should be asking themselves whether the Bank will continue hiking the repo rate given moderating inflation, and with other emerging markets beginning to cut rates.

While we don’t believe the Bank will cut rates as fast as it hiked and is likely to keep the repo rate ahead of inflation, money market yields are at risk of trending lower. Meanwhile, bond returns should respond positively to a lower repo rate — driving relative outperformance of long bonds. 

Yields on local government bonds provide capital protection 

While SA’s government debt (forecast to reach 80% of GDP in the near term) is not out of line with other emerging markets, low growth projections lead many to question whether government bonds will remain a safe store of capital.

While we do not intend to underplay the importance of continued fiscal prudence, taking a closer look at the metrics we don’t believe a debt crisis is likely in the medium term. SA has a well structured debt profile, with only about 12% of long-dated bonds maturing over the next four years.

The Reserve Bank has also had a world-class track record since implementing its inflation-targeting mandate and inflation is less likely to exceed target levels on a sustained basis. If a debt crisis is a low-probability scenario and inflation averages 5%-5.5%, investors who buy these government bonds at an average yield of 12% today will earn inflation plus 7%, which is on par with long-term equity real returns.

Importantly, this is not premised on a high-growth environment in SA. The rate cutting cycle (and potential for a slightly better environment) further adds optionality of capital appreciation to the investment thesis. 

Developed market rates offer more risk than reward 

US yields are now five times higher than during the global financial crisis, and thus many investors are wondering if it isn’t time to consider offshore fixed income assets. While we do see (and use) the diversification benefits of offshore assets, we would be cautious of allocating capital to developed market bonds.

Investors make a critical call when shifting assets offshore, as we have seen in the past year both on the valuations of the assets they buy and on the currency risk. 

In our view developed market bonds pose a risk of capital losses as key markets (the US, UK and Japan) continue to run budget deficits against substantial debt maturities. The US has about 46% of its debt maturing in the next four years. This creates a cocktail of bond issuance at a time when yields are five times higher than recent years, producing a spiral of interest costs.

We also don’t believe developed market inflation will be contained at the 2% target rate, given that supply side constraints will take multiple years of investment to resolve. These headwinds are likely to force yields higher, resulting in poor returns for investors. 

Ensure your portfolio is correctly positioned 

While money market and offshore rates may appear attractive, we believe these areas have to be navigated with care given the uncertain macro environment. We believe multi-asset income funds are well placed to provide investors with inflation-beating income exposure in a manner that preserves capital and manages short-term volatility.

More importantly, PSG Asset Management’s dynamic approach in our multi-asset fixed income fund means we evaluate the environment on an ongoing basis and adjust portfolios (and tailor our assumptions) as the environment evolves.

This is especially important because to unlock the silver lining that is on offer, investors will need to ensure they partner with an investment manager who can assess the risks and opportunities in the market rationally, and construct robust portfolios that take care to manage the risks and avoid permanent capital losses. 

PSG’s 3M investment process helps to ensure we assess risks and opportunities in a disciplined manner and construct robust investment portfolios suited to challenging environments. 

•  Sankar is head of fixed income at PSG Asset Management.