Bonds are down but not out
Inflation-linked bonds have returned nearly 16% in 2021, compared to a return of 8.5% for nominal bonds.
These are respectable returns by most measures, given that cash in 2021 returned 5.5%, slightly ahead of consumer inflation of around 4.5%.
The chart below shows the different yields of inflation-linked bonds, nominal bonds and cash.
Nominal bonds are also known as fixed rate bonds, reflecting the fact that their coupons (or interest rates) are fixed in the nominal sense, meaning that if the coupon rate is 9% per annum , this is the interest rate you will get per year.
Inflation-linked bonds, as their name suggests, offer a coupon rate tied to the rate of inflation. This rate is variable, unlike the nominal coupon rate which is fixed.
Sandile Malinga, portfolio manager at M&G Investments (which is the former Prudential Investment Managers South Africa), says the outlook for bonds remains surprisingly positive, despite two years of solid returns, particularly from inflation-linked bonds.
“After a few very good years for inflation-linked bonds, we think it’s prudent to start turning some of those earnings into nominal bonds. Investors tend to worry a bit about these assets after they’ve had such a strong run, and they tend to look to cash as an alternative.
“While cash is a useful asset to have in times of stress, over the longer term it has provided lower returns than nominal and inflation-linked bonds. Although there are sometimes long periods of under -performance, we still expect nominal and inflation-linked bonds to generate higher returns than cash in the future,” adds Malinga.
Nominal and inflation-linked bonds play an important role in portfolios aiming to generate real returns of 5% or more.
Yields on cash were as high as 7.5% before the Covid shutdowns, but fell sharply as central banks around the world cut interest rates. This attracted funds to undervalued bonds.
Regarding the claim that bonds are currently risky, Malinga’s analysis leads to a different conclusion.
“The chart above shows what happens when we accumulate and reinvest our interest returns. Unlike the first chart which shows the volatility of returns over time, the chart above shows how that volatility fades over time. over time if returns are reinvested, demonstrating that the income component is the primary driver of long-term returns.
“From this perspective, we find that our income assets have very low medium to long-term capital volatility. So, in our opinion, bonds are not as risky as many think and carry much less risk than stocks, for example.
The chart above compares the expected returns of different asset classes and presents listed assets and equities as the assets with the highest return prospects.
“We always look to the future and assess the relative attractiveness of assets,” says Malinga.
“Following the recent rally, nominal bonds are priced to offer better yields than inflation-linked bonds. If we look at the valuations of these two assets today compared to a year ago, we can see that as of today, nominal values are priced to offer more than 5% real over the medium term, while inflation-linked bonds, after rebounding through 2021, are now priced to deliver just under 4% real. This remains attractive, but the relative valuation favors nominal bonds. As a result, we have shifted quite significantly in valuations, taking profits on our exposure to inflation-linked bonds and reinvesting them in nominal bonds.
The link between interest rates and equity performance is tenuous, adds Malinga.
This was demonstrated in 2016 and 2017 when the US Federal Reserve raised interest rates with relatively minor impact on stock prices – in fact, US stocks rose 14.7% annually during that time. period.
Similarly, there is no certainty that a sell-off in US bonds will be reflected in SA. South African bond valuations appear to be helping to protect local bonds against a rise in global bond yields.
Real bond yields are the best since 2000
M&G Investments research shows that bonds are currently priced to offer high real yields.
There is a strong relationship between starting yields and subsequent yield. Low starting returns are associated with low future returns, while high starting returns are associated with high future returns.
Malinga says the index’s current yield is around 10%, more than double the rate of consumer inflation. “This suggests that bonds offer real returns of 5% to 6% over the medium term. These are some of the highest real yields available on bonds since 2000. This is part of the reason why we like to have nominal bonds in our portfolios.
What about inflation issues?
Investors are increasingly worried about inflation, knowing that it erodes the real value of assets. Malinga points out that this argument certainly applies to foreign bonds that are highly exposed to inflationary pressures. The same cannot be said for SA nominal bonds.
“If we take the current nominal yield on 10-year SA bonds of 9.8%, we can decompose it into a real return component of 3.6%, a medium-term expected inflation of 4.5% and a premium inflation risk of 1.7%. This 1.7% is a safety cushion that investors can take advantage of, over the next 10 years. This is quite generous in our view, especially given the strong track record of the South African Reserve Bank in the fight against inflation.
M&G Investments has always had a heavy weighting in inflation-linked bonds, which are strongly linked to real estate and which over time have generated a decent return.
“We were at the beginning of this cycle and the performance suffered as a result,” says Malinga.
“Then, inflation-linked bonds outperformed, yielding a 16% return in 2021, compared to an 8%-9% return for nominal bonds. We always make decisions based on current valuations, so nominal bonds look more attractive today. We started taking profits on inflation-linked bonds and reinvesting in nominal values.
With a current yield of 9.8% on nominal bonds and a yield of 3.6% on inflation-linked bonds, the difference of 6.2% is the implied inflation rate – that’s the rate inflation expected by bond investors over the next 10 years. Malinga says this is overcompensation, as the Reserve Bank is unlikely to allow inflation at this level over the next decade.
One quirk of the current market is that US inflation is currently at 7.5%, well above the SA inflation rate of 4.5%. It is the first time in decades that US inflation has exceeded that of South Africa.
It’s not just about bonds, it’s about the bonds you choose
Picking bonds is a smart move, but equally important is knowing which bonds you pick – active stock picking in 2021 could have resulted in returns as high as 25% or as low as 4% (barely beating cash ).
A similar disparity in yields was evident in the bond market (as seen in the chart), so knowing which bonds to pick was another crucial part of generating superior returns, Malinga says.
Presented by M&G Investments.
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