As Fed cuts rates, local bonds are looking their most attractive in years
Low inflation and declining interest rates globally are contributing to the perfect environment for South African bonds to perform
Bonds currently offer one of the best opportunities in years to earn above-inflation returns and provide good diversification at relatively low risk, according to local asset managers.
While global bonds are expensive, South African bonds are cheap, and the investment case for them is stronger than for their global counterparts, according to Ian Scott, the head of fixed income at Momentum Investments.
Low inflation and declining interest rates globally are contributing to the perfect environment for South African bonds to perform, he says.
The big turnaround for local bonds was when the US Federal Reserve announced it would cut interest rates. At present, most central banks are in an easing interest rate cycle, Scott told a recent Momentum Investments seminar.
Events in the US affect world markets and, according to Scott, although the US may not go into a recession, it may be heading for an economic slowdown next year.
One of the first things President Donald Trump did after taking office was to cut taxes, forcing the government to borrow on the bond market to fund the resultant shortfall in revenue, Scott says.
If many more bonds are launched into the market, it will negatively affect the longer-dated US bonds and the actions of the Fed. The US housing market is also heading for a slowdown, which will put further pressure on the Fed to cut rates.
In the return on longer-dated bonds, which mean you can expect a return of about 4% above inflation
In contrast, interest rates in SA are quite high considering the low economic growth and low inflation rate. Bonds are cheap because the market has already priced in the negative sentiment about the country and state-owned entities such as Eskom.
But investors should remember the bond market is continuously pricing in risks. At the moment a fair amount of risk is reflected in the bond yields, Scott says.
The yield on longer-dated bonds is at more than 9%, which means you can expect a return of 4% above inflation (currently at 4.5%) over the next three years without taking on excessive risk, he says.
These low bond prices coupled with inflation that is expected to remain below 5% over the next three years present one of the best investment opportunities in 10 years in the South African fixed-income market, Scott says.
Speaking at the Collaborative Exchange's "meet the managers" conference recently, Philip Bradford, the chief investment officer at Sasfin Asset Managers, said investors should take advantage of the opportunities that bonds are now offering.
Unlike shares, where cash flows and future values are uncertain, when you invest in bonds you know exactly what the cash flow will be, and only the capital (the price of the bond) moves up or down, Bradford says.
Considering historical returns, if you bought the 10-year bond at the current yield you could expect returns of 10%-12% over the next five years, he adds.
On concerns about a ratings downgrade and its impact on the bond market, Bradford says that just before Russia, Brazil and Hungary were cut to junk status, their bonds were sold off in anticipation of the move. However, by the time the downgrades took place, the markets had already started improving and 12 months later their bonds had all appreciated significantly.
SA has had four years of "practice with downgrades" since former president Jacob Zuma fired the then finance minister Nhlanhla Nene. Given the economic weakness, if we were not heading for a possible downgrade, the longer-dated domestic bond yields would be at least 2% lower than they are, he says. In other words, much of the bad news is already priced in.
Bradford says the difference in yield on US and local bonds is 7%, and is likely to more than compensate for expected depreciation in the rand in the long run.
Inflation in the US is around 1.5%, which means the rand should only depreciate by about 3% a year against the dollar - the difference between the inflation rates in the US and in SA, he says.
Justin Floor, manager of the PSG Balanced Fund, says while South African government debt has increased over the past few years, this debt has a very healthy maturity profile.
While many market commentators agree that South African bonds appear to offer good value, many are waiting for conditions to improve before investing. But Floor warns that investors should not wait too long as no-one can predict when the turning point will be and prices can normalise dramatically.
SA market in perspective
By LAURA DU PREEZ
It is very easy to beat up on SA, but the performance of the country's markets should be put into perspective, says Kevin Lings, chief economist at Stanlib.
The equity market should not be compared to the US market but rather to other emerging-countries' equity markets. "SA is a messy emerging market and there are lots of them. We stack up well against them," Lings told the recent Allan Gray Investment Summit in Cape Town and Johannesburg.
However, emerging-market equities, especially outside of Asia, are not doing well, he says.
"The world is not in love with emerging-market equities, but is in love with emerging-market bonds," he said, explaining this is largely a result of lower yields from bonds in developed markets.
Foreign buying of South African bonds since 2010, cumulatively, is positive, although it has been fairly lacklustre in recent years, Lings told Money.
More recently, foreign investors have been influenced by the deterioration in SA's fiscal position and lower credit ratings. Also, foreign investors already own a significant percentage of the government's debt, said Lings.
The looming tax revenue shortfall, more funding for SOEs and rating agency Fitch's decision to change SA's credit rating outlook from stable to negative have made investors nervous, said Lings.
Despite this, because the world is clamouring for higher-yielding assets, the South African government can still sell bonds to the market, though not as easily as some other emerging markets, he said.