Beleaguered inflation-linked bonds

Author: Rowan Williams-Short, Head: Fixed Interest, Vunani Fund Managers

Inflation-linked bonds (ILBs) arrived in South Africa in March 2000, well ahead of even most developed markets, but with a whimper. At the time, markets were still in the throes of Y2K paranoia and the first serious cracks in so-called TMT shares were appearing.  On top of that, the South African market was ill-prepared for these new instruments. Just one ILB was initially issued – the R189. A combination of novelty, disinterest and ignorance lead to an inaugural real yield of 6.76%, with a government guarantee! The R189 matured in March 2013, having delivered on its promise.

For the next ten years, the performance of ILBs relative to nominal bonds more or less tracked the change in the inflation rate, as one would expect. From 2010, when the obvious appeal of ILBs to any pension fund and the rise of specialist asset-liability matching strategies really took hold, ILBs hugely outperformed nominal bonds, until December 2015. Since then, ILBs have underperformed nominal bonds by an astounding 29%. Some of this can be ascribed to relative starting valuations. ILBs were demonstrably expensive by the end of 2015, while the bloodbath in nominal bonds caused by “Nenegate” had rendered those excessively cheap. Even more of the underperformance can be ascribed to the extent to which inflation fell far faster than economists expected.

Today, real yields on government ILBs in South Africa range from 2.9% (3 years) to 4.9% (30 years), the latter being the highest level ever. An asset guaranteed to outperform inflation by nearly 5% a year (*) deserves to be placed in context. Over the past 30 years, vastly riskier equities have delivered 6.9% p.a. over inflation. Right now, despite the rapid recovery from the COVID lockdown shock, equities are 5.5% behind inflation over the past six years. Over the past 30 years, nominal bonds, which are not guaranteed to beat inflation, have delivered 5.4% p.a. real. It is clearly time for ILBs to take their rightful place in any pension fund or retirement plan. No other asset class defeases inflation-linked liabilities with nearly as much panache! 

(*) Readers are cautioned that a government guaranteed ILB yielding say 4% means that this ILB will outperform inflation by an annualised 4% between now and its maturity date, but this does not mean that it will outperform inflation by 4% each year between now and the maturity date.