Local fixed income is looking very attractive - PSG
Nominal and inflation-linked bond curves are reflecting close to all-time high yields. They therefore appear to be pricing in both a high probability of a credit rating downgrade to sub-investment grade, and a disaster-type scenario that will require an IMF bailout.
In contrast, developed-market bond yields have declined significantly, as expectations of higher inflation and growth have somewhat subsided.
Our analysis indicates that the prices of local government bonds do not reflect the reality of South Africa’s fiscal position - which is more balanced than most market participants give credit for. This disconnect between price and value offers attractive risk-adjusted returns - particularly in a global context. The $5 billion (R73.5bn) South African Eurobond issuance in late September supports this view, and clearly indicates that global markets also see significant value in local debt at current levels.
Negotiable certificates of deposit, corporate credit and bank credit have performed well over the past three years. This can be attributed to the fact that absolute yields have been high relative to history, resulting in the instruments generating strong income returns. However, both absolute yields and credit spreads (the excess yield paid as a risk premium) have fallen materially, reducing the odds of achieving similar outcomes going forward.
History has shown that over the medium term returns from local fixed-income markets are driven largely by starting real (above-inflation) yields: the higher the starting real yield, the higher the subsequent return.
Inflation is reasonably well anchored around the middle of the South African Reserve Bank’s target band of 3 percent to 6 percent, with little risk of this being exceeded. This implies that long-dated government bonds are currently delivering real yields in the range of 4 percent to 5 percent (from starting yields of close to 10 percent) at low levels of risk and with significant upside potential if real yields normalise. Similarly, real yields on inflation-linked bonds - at close to 3.5 percent - are at all-time highs, offering attractive absolute returns in addition to diversification benefits. This is in stark contrast to falling yields in the floating-rate and cash-like areas of the market, and therefore looks likely to be the better risk-adjusted opportunity for clients in the years to come.
We believe that the current environment offers attractive opportunities for investors in need of income - but that not all options are equally attractive. Given the current imbalances in credit markets, duration (interest rate risk) is likely to be better rewarded than credit risk. There is also the possibility that investment into riskier credit grows in an effort to maintain the high yields this market has offered in recent years. It is therefore crucial for investors to be discerning when investing in fixed-income securities.
Lyle Sankar is a fund manager at PSG Asset Management.