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High yields, low prices are making bonds an attractive buy

Published Jul 5, 2022

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Bonds are largely regarded by investors as the “boring cousin” to shares (equities), and for the most part this is true: they generally come with low investment risk and stable, if pedestrian, returns. However, like shares, their prices can fluctuate according to supply and demand. And the global bond market has seen big sell-offs in recent months.

Although inflation and interest rates continue to rise, bond investment experts are beginning to see good value in bonds and are making a case for buying into this asset class.

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There are various types of bonds: government and corporate bonds; fixed-rate and floating-rate bonds; bonds of short duration, whose rates reflect the prevailing cash rates; and bonds of longer duration (as long as 30 years), which have higher rates because investors have to factor in unknown future risks.

Rates, yields, prices

In times of rising inflation, central banks raise interest rates, bond prices fall and their yields rise. To understand the relationship between interest rates, bond yields and bond prices, let’s take a simple example:

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The government wants to raise money for infrastructure. It issues a 10-year bond at a fixed rate (the “coupon”) of 8%. Inflation is 5% and the bank lending rate is 6%. For a single bond of R1 million, Buyer A receives a yield (the interest payments on the bond) of R80 000 a year. But then inflation picks up, and the government hikes interest rates to combat the rising inflation – say inflation rises to 6% and the bank lending rate to 7%. This bond is now looking far less attractive to Buyer A: his real (after-inflation) return of 3% has shrunk to 2%, and he reckons he can get a better return elsewhere. So he sells the bond, but no-one wants to buy it at R1 million, and the best offer he can get, from Buyer B, is R900 000. Because he bought it at a lower price, the yield for Buyer B is higher than that for Buyer A. The R80 000 interest payments on the bond haven’t changed, but they represent an 8.9% yield on his investment (R80 000 is 8% of R1 million, but 8.9% of R900 000).

Fund managers specialising in bonds are acutely tuned in to the inflation/interest-rate environment and to economists’ and analysts’ inflation expectations.

The current environment is unlike anything we have seen for more than a decade. As inflation has soared globally – beyond initial expectations – and central banks are desperately raising rates in reaction, bond prices have plummeted and yields have risen.

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Opportunities in bonds

In a recent article, “Bonds are back – here’s why”, Paul Grainger, head of global fixed income and currency at Schroders, says a record sell-off against an economic backdrop becoming more supportive of bonds means there are now opportunities in the global market.

Grainger notes that, between January last year and mid-May this year, the Bloomberg Global Aggregate Bond Index dropped 17.6%, the biggest drop since data began in 1990. In comparison, he says, the peak-to-trough decline during the 2008 global financial crisis was 10.8%.

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He says there are three main reasons why bonds are particularly attractive at the moment:

1. Valuations: yield levels are appealing again and there is good return potential.

2. Bonds are a good diversifier, particularly in periods of economic uncertainty.

3. The rate hikes currently priced into bond markets won’t all be delivered as inflation peaks and growth slows.

Grainger says the unprecedented conditions of the past decade or so – almost non-existent global inflation and ultra-low interest rates – saw historically low yields.

“That has decisively changed. The current turmoil, while painful and unsettling, is increasingly presenting opportunities. Valuations have, in our estimation, overshot macro-economic fundamentals. Over time, they should revert back,” he says.

He believes bonds will offer a safe-haven if we enter a recession. “Bonds are well worthy of consideration for investors looking to navigate difficult global conditions and generate income returns.”

Aren’t rising interest rates a worry?

Grainger and other analysts believe that current bond prices already reflect a full cycle of interest-rate hikes by central banks – this is the series of hikes the banks will make over the coming months to counteract inflation. And herein lies opportunity, because, according to Grainger, many of these rate hikes will not be realised. This, he argues, is because inflation itself will act to curb economic growth, and inflation may already be peaking.

In an article “Bonds 101: rates are rising – how does this impact investors?”, Roné Swanepoel, business development manager at Morningstar Investment Management SA, also believes the market has priced in all interest rate hikes. “Bond prices have already moved on the expectation that US interest rates will increase to 3% by the end of February next year. In turn, given the relationship between interest rates and bond prices, this has caused a sell-off in bonds.

“In the last couple of weeks, bond markets have begun to warn of a potential recession due to short-term yields rising above longer-term yields. Effectively, the market is saying that interest rates may rise in the short term to combat inflation, but in the long term, rising interest rates may actually slow economic growth. If these warnings are correct, then this could bode well for bonds, as they typically perform well in a recessionary environment.”

South African bonds

Lyle Sankar, head of fixed income at PSG Asset Management, in his article, “Opportunities for local fixed income investors remain attractive, despite the global bond rout”, says the South African bond market has held up quite well in contrast to the US experience. “We believe SA government bonds are likely to be one of the best performing asset classes in the years ahead on a risk-adjusted basis,” he says.

“Risk perceptions around SA government bonds have been elevated for some time, contributing to elevated yields, especially at higher durations. Thus, we have one of the cheapest government bond markets on our doorstep, offering some of the most attractive real yields globally. The 10-year government bond currently yields above 10% (more than 4% above inflation).

“Since 2016, government bonds have earned an inflation-beating average annual return of 5.3% above inflation. We believe this can continue,” Sankar says.

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