Investment opportunities within Fixed Interest amongst the many Covid-19 risks

Author: Rowan Williams-Short (Head: Fixed Interest)

“Boring bonds” have been anything but boring. Over the past seven years – a period usually considered long enough for asset classes to show their true colours – the All Bond Index has:

  • Outperformed the All Share Index
  • Outperformed inflation-linked bonds
  • Outperformed listed property
  • Outperformed cash
  • Outperformed inflation

…bonds tend to deal a bit better with bad news.

The backdrop has hardly been especially kind to bonds. This period covers the calamitous dismissal of a well-regarded finance minister, a shocking deterioration in the country’s fiscal position, bankruptcy of several SOEs, multiple sovereign downgrades, expulsion from the World Government Bond Index and a very stringent lockdown of economic activity. The sterling performance of bonds, accompanied by that list of assorted disasters demonstrates the futility of top-down analysis (implemented as active duration positioning within fixed interest) and the critical importance of assessing what has already been discounted, or priced into bond yields. Bond investors tend to be more pessimistic than equity investors who are more frequently inclined to discount utopian scenarios. Therefore, bonds tend to deal a bit better with bad news. From June 2016 to August 2018, the All Share Index’s price: earnings multiple averaged above 20 – far above the average of the past half century, of 12.6. This belied expectations of an extraordinarily bounteous period of earnings. Listed property at the time operated even deeper in Lala land. The lesson is that valuations beget concomitant returns.

So much for the past. Has the heightened volatility initiated by the COVID-related lockdown delivered opportunities within fixed interest, or have these already come and gone?

Let us examine the recent behaviour of RSA government bonds. Whenever markets experience elevated volatility, the word “unprecedented” is cast about widely. That is seldom the truth; it is more of a cliché. The lockdown has delivered some eye-catching asset price behaviour, but in neither the equity market nor the bond market has it been unprecedented. For example, the loss of 9.75% by bonds in March 2020 is put into the shade by the loss of 14.43% in August 1998. Likewise, the equity market’s loss of 14% this March is less than half the loss of 29% in August 1998.

Nonetheless, 2020 has delivered highly unusual, if not unprecedented market behaviour. The All Bond Index is up 2% year-to-date and is no longer a dripping roast. However, the frantic cutting of short-term interest rates by the SARB has been almost mechanically and necessarily matched by short-dated bonds but greeted with a whole lot more circumspection by long-dated bonds. This combination has rendered all-time steepness (yes – that is unprecedented!) in the slope of the yield curve. Investors willing to take incremental risk receive more marginal yield for each extra year of term than ever before. This observation must be tempered by soaring the debt: GDP ratio and the imminent ballooning of the budget deficit. Against that, the windfall of the plummet in the oil price bodes well for ongoing returns comfortably ahead of the inflation rate.

The catch, which should not matter to retirement fund and other long-term investors, but always does, is that patience is required.

Indeed, one need not take chances on generating positive real returns from nominal bonds (or equities), when long-dated, government guaranteed inflation-linked bonds offer real yields of over 4.5%. Quite rationally, nominal bond yields are priced to deliver somewhat higher real returns. The catch, which should not matter to retirement fund and other long-term investors, but always does, is that patience is required.

Beyond government bonds are the other 1,778 listed debt instruments issued by SOEs, metropolitans, banks and corporates. In the face of large-scale asset impairments, yield spreads of bank instruments have widened significantly in 2020, and particularly in subordinated debt. It is our contention that when so-called AT1 instrument offer yields of more than 500 basis points above JIBAR, too much pessimism has been priced in. The SARB’s steely resolve on banks’ soundness adds to our conviction.

Prudence dictates that more caution than ever must be exercised when investing in SOE bonds.

Prudence dictates that more caution than ever must be exercised when investing in SOE bonds. Eskom is too critical to be allowed to fail, but the recent default by the Land and Agricultural Development Bank, an erstwhile beacon of light among the beleaguered SOEs, was sharply sobering. National Treasury did not see its way to making an emergency allocation of a relatively trifling R5bn to avert the default and so rational investors must read through this to other SOEs. Denel cannot pay staff salaries. ACSA’s revenue has been decimated by the overnight evaporation of aviation. The pittance that SANRAL collects in tolls from reluctant motorists has been further eroded. TCTA labours under a qualified audit and problems related to acid drainage and dispossession of subsistence farmers.

There are always opportunities along the fairly homogeneous term structure of government bond yields, and more so in the relatively heterogeneous corporate and bank sector, but the shocks of the past few months have enriched these opportunities further.