BONDS: the Cinderella of asset classes?
Candice Paine

We all heard it. The thing Andrew Canter of Futuregrowth said about not selling bonds to his grandmother right now. Asset allocation 101 always stipulates that we should hold bonds on a long term basis because they limit portfolio volatility and should give inflation beating returns. Well, yes in theory this works, but it's sometimes more of a rollercoaster ride than this.

Look at the chart below. The red line along the top shows the cumulative drawdowns of the All Bond Index. There have been times when this seemingly innocuous asset class has been anything but protective of assets. Bond prices move inversely to interest rates. And with inflation targeting as the primary goal of our Reserve Bank, inflation (ok, yes, GDP growth, the BOP and the currency too) in a manner dictates interest rates. The chart gives us a sense that as rates rise, bonds lose. So yes, right now, you probably shouldn't be selling bonds to your grandmother. But when should you?

If you buy a bond and hold it to maturity, then it makes little difference what interest rates are doing because you will receive the yield you have chosen and your capital. If you're going to trade them however, then you need to have a view on interest rates and growth. South African Monetary Policy focuses on keeping inflation between 3 - 6%. This is effectively achieved by raising or lowering interest rates to increase or decrease the money supply. And all of this is as a result of the business cycle. Money supply may be tightened during the late stages of the up cycle to prevent 'overheating' and summarily lowered going into a slow down to stimulate demand.

Interest rate forecasting is notoriously inaccurate so it is better to follow a consensus view rather than one market participant. Views on interest rates can be modeled, but can also be an intuitive assumption based on observations of the socio-economic-political climate. An interest rate is in fact the price of money and should be determined by supply and demand. The downside of this is that inflation is always just a moment away. So taking inflation into account, simplistically future interest rates should be the current real risk free rate plus your inflation expectation. If everything points to inflation rising, then interest rates will rise - and you probably shouldn't be investing in longer dated bonds at the moment. Conversely, if demand (measured by indicators like car and retail sales and the Balance of Payments) is falling, inflation will probably decline and so should interest rates. This is when you should buy bonds because new issues will be sold at much lower interest rates.

When inflation is consistently rising, the inflation expectation becomes larger and larger and it almost takes a structural change to lower this in the minds of investors. As a result they demand higher and higher rates at which to lend their money out.

As mentioned before, Monetary Policy, actioned by the Reserve Bank influences the supply side of credit by raising or lowering rates and fiscal policy through its control of tax levels also plays its part.

Ok, now that you have an idea of where rates are going, let's look at the bond market. Currently South Africa is displaying an inverted yield curve. Loosely, when a yield curve inverts i.e. short rates are greater than long rates, this usually portends more difficult economic times ahead and reflects investors' concerns around rising uncertainty. Investors need to be compensated handsomely for tying up their capital for long periods of time at the long end of the yield curve, but uncertainty over economic conditions means they are not expecting this payoff as the risk premium has been eliminated.

When investors believe hard times are coming, they may buy long term bonds because they are safer than stocks and are attractive when inflation is low. This trade is based on the fact that recessions usually beat inflation down. This buying drives down the yield on the long end of the curve causing it to invert. The good news here is that they believe inflation will come down in the future. In our case, the Reserve Bank has committed itself time and again to inflation targeting so they have at least given us the assurance that they will do everything in their power to bring inflation back into the band. This, coupled with the Reserve Bank consistently raising the repo rate means that at the moment, it is more profitable to invest at the short end of the curve.

This doesn't mean there aren't opportunities for investors with this yield curve shape. It just means they need to be more careful. Further, inversions don't last forever. When the inversion corrects, you would need to adjust your portfolio accordingly. We will probably see the South African curve flattening out once fundamental news starts improving i.e. once we see inflation back under control and falling and once we are more certain that the Reserve Bank has come to the end of its interest rate tightening cycle.

So given that we said a view on bonds is really all about your views on inflation, how can we determine more accurately if nominal bonds are showing value? We need to forecast the yield on a bond. To do this, add your inflation expectation plus the inflation risk premium to the current real yield on the nominal bond. The real yield is the current yield adjusted for current inflation. Your inflation expectation is a little more tricky but can be calculated by subtracting the yield on the nominal bond from the yield of an equivalent inflation-linked bond. And then there's the inflation risk premium which is a slippery number because it needs to reflect the risk of inflation changing (dramatically) during the period for which you have calculated your inflation expectation (and hence eroding your purchasing power). Once you have calculated your yield expectation, compare it to current yields and then simply make your trade accordingly!

This article is just touching the tip of the iceberg in the complex world of bonds, but what it does emphasise, is that there are better and worse times to be invested in bonds, especially if you aren't going to hold the instruments to maturity. Once you've decided whether you are there for the long term or the short term, the decision as to which bonds to hold becomes easier given that you have some thoughts as to where we are in the current economic cycle. Bonds have shown the ability to generate income and protect capital over the long term and should form a part of any portfolio's strategic asset allocation. Just remember that these investments do come with risks.