By Candice Paine, 11 February 2013
In a sub-prime crisis investment world, official interest rates have reached historic lows as a result of the unprecedented monetary policy easing that has been implemented in the hope of kick starting global economic growth – and it looks like they could remain there for even longer (see economic analysis on page 4). But what that means for bond yields, nobody really knows.
Against this backdrop, the only way bond investors are likely to survive and thrive in this changing fixed interest investment landscape is to know their stuff and adapt their investment strategies accordingly.
Those most affected are investors who rely on the income generated by fixed interest assets, such as government or corporate bonds, or who have multi-asset class exposure, which have inevitably included a healthy dose of fixed interest assets to take advantage of their lower volatility, income-generation and diversification characteristics.
So the million-dollar question facing many investors: what to do about it? Well the first step is to avoid the hype and go back to basics so that you know exactly why you invest in bonds, what they do and don’t offer – and how this could change.
Then you need to determine how you want to respond and what you can expect if you decide to, for instance:
Bonds are the steadier-as-she-goes asset class that generates income for investors and, a secondary consideration, capital growth. Historically bonds have been less volatile than equities and thus offer investors attractive diversification qualities in a multi-asset class portfolio.
Government and corporate bonds are loans that the bond investor makes to a bond issuer i.e. the corporate or the government. Like a loan, a bond pays interest periodically and repays the capital at a future date when it matures. The bond yield is the actual return an investor can expect if the bond is held to maturity – and is based on the price of the bond and the coupon. The coupon is the interest rate stated on a bond when it’s issued. The coupon is typically paid semi-annually. So a R1 000 bond with a coupon of 7% will pay R70 a year.
In the current environment where yields are low, it’s important to remember that yield is only one of two components of a bond portfolio’s return. The other is the capital gains or losses that arise as a result of the change in the price of the bonds held in a portfolio. What this means is that if government interest rates rise, the value of the government bond declines and investors lose capital.
Those considering whether to maintain their current fixed interest allocation need to take into account that if yields stay at current lows, their income distributions will remain lower than in the past, and if yields rise, they could potentially face capital losses.
But it’s not necessarily as straightforward as that. Globally in the past income has tended to cushion the investors’ total returns from the impact of capital losses. That is why the asset class has historically generated consistent, and less volatile, total returns (including capital and income) over time.
According to a paper by Goldman Sachs, the Barclays Global Aggregate Bond Index generated a capital loss due to rising interest rates in four of the last 11 years but the total return was still positive for all those 11 years because the income more than offset the decline in the price.
However, in a low yield environment, that income may provide a smaller buffer from capital losses, possibly changing the risk/return profile of bonds should the price of bonds change significantly or suddenly.
But rising yields are also not necessarily synonymous with negative returns, according to a research paper published by Canadian-based Russell Research, which concludes that it’s not only the absolute level of the rise in yields that matters, but the time frame within which that rise occurs. So if yields move gradually higher over the next few years, bond investors would not be too adversely affected.
Other reasons bond yields are not likely to fall out of bed overnight are that, in the case of the developed world, monetary authorities have created a constant source of demand for government bonds as a result of monetary policies, such as quantitative easing, and in the case of emerging markets, better growth prospects and fiscal positions are proving attractive to investors.
In SA, though historically low, government bond yields do trade at higher levels than their developed market counterparts (the SA 10 year bond ended the fourth quarter of 2012 at 6.78% versus the US 10 year government bond at 1.84%) so there’s more of a yield cushion. SA government bonds have also benefited from the inclusion of 12 bonds in the Citigroup World Government Bond Index (WGBI) as well as the broader global appetite for higher yielding emerging market government bonds, notwithstanding Standard and Poor’s downgrading the credit rating for SA government bonds to BBB towards the end of September.
Within a lower yield environment, there’s a temptation – and often a real need – to seek out higher yielding assets, such as corporate, which offer a wide and growing array of choice, and emerging market bonds, which trade at a two percentage point premium to US Treasuries – considered the world’s risk-free benchmark rate. But the particular risks and attributes of these assets need to be considered carefully because they do change the risk/return profile of a portfolio.
So, a few things to consider when exploring your higher yield universe of bonds are:
When it comes to emerging market bonds, in particular, Goldman Sachs reflects the prevailing sentiment when it notes: “From a fundamental perspective, many emerging economies offer stronger growth to support their debt and budget situations that are strong and improving rather than weak and deteriorating, as is the case with many developed country sovereign bonds.”
Given the greater potential risks you are exposing yourself to when you move into higher yielding fixed interest territory, it’s a good idea to know what you’re doing. For the average investor, it is advisable to access that expertise by investing with an active manager who has the experience and proven track record for managing a portfolio that aims to maximise yield and manage the particular risks of investing across the many available options in this spectrum of the fixed interest universe.
For the risk-averse investor concerned about the potential risks encapsulated in historically low yields, cash obviously offers the comfort of capital security – but exposes the investor to the risk of inflation eroding returns over time. In fact, in SA, cash is currently providing very little, to no, real returns and that could continue given the low growth, low interest environment that is likely to prevail for the foreseeable future. So if you want to increase your allocation to cash, think carefully about time period and whether the risk that it may go backwards in real terms outweighs the risk of possible capital loss in the fixed interest world.
Many investors seeking higher yields have found them outside the asset class altogether – investing in high dividend yielding stocks or portfolios. But there are risks here too. Globally demand for high dividend yielding investment exposure has been strong, given investors can achieve a yield of 3% compared with a US 10 year bond yield of about 1.6%. Despite some pull back in dividend yields to below 3%, global dividend yields remain above their long-term average of 2.5%. In SA, forward dividend yields compressed sharply during the year to trade below 3%; below their long-term average of more than 3.2%.
Given these structural changes underway in the fixed interest environment and the strong returns the asset class has delivered in the past – globally a top performer for the past three decades – it’s important to manage your expectations regarding what is likely to be a reasonable return going forward.
After conducting in depth research last year and taking into account the likely impact of financial repression, SIM found it prudent to lower its long term required real return assumptions for global and local bonds in October last year by a percentage point. It uses these real returns to gauge whether an asset class is offering value or not based on what it expects to achieve from it over a long-term time horizon. In the case of bonds, this is a 2% real return for local bonds and 1% real returns for global bonds.
Not much to write home about compared to what we have come to expect over the past few decades. So the key to getting all you can out of the asset class going forward will lie in stepping out of your comfort zone, taking advantage of the opportunities that are undoubtedly out there to boost yield and finally, but most importantly, to be cognisant of other potential risks you may be introducing to your investment portfolio – and managing these carefully yourself or leaving it up to the experts.