Article sourced from Financial Mail.
Despite a great January start and a good run in 2016, bonds are not guaranteed an exceptional showing in 2017.
After putting on an exceptional showing last year, bonds have got off to a solid start in 2017. The JSE all bond index (Albi) delivered a total return of 2.3% in the first three weeks of January. Bonds were the place to be in 2016, with the Albi crossing the finishing line sporting a total return of 15.4%. The JSE all share index managed no more than a 5.5% total return.
A repeat of last year’s winning performance from bonds is far from certain, though. “Bond yields started 2016 from high levels,” cautions Albert Botha, an Ashburton Investments fixed income portfolio manager.
As always, it is important to remember that when bond yields rise their underlying prices fall. When their yields fall, bond prices rise. The headstart enjoyed by bonds in 2016 came courtesy of President Jacob Zuma’s firing of finance minister Nhlanhla Nene in December 2015. Zuma’s action resulted in SA having three finance ministers in four days and made the yield on the key R186 10-year government bond jump from 8.7% to 10.6% in less than a week. It was the R186’s highest yield since the 2008 global financial crisis.
SA’s homemade financial crisis ended with Pravin Gordhan’s reappointment as Minister of Finance in mid-December 2015. Bond yields began tumbling, with the R186’s falling to 9% within eight weeks of Gordhan’s return.
There was another tailwind for SA bond yields in 2016, from a renewed appetite for emerging market bonds in general. It left the Barclays Emerging Markets Local Currency Government Bond Index boasting a 25% total return by year-end. The R186 is now trading at around the 8.7% level, having fallen from just over 9% in early December.
The big question is: where to from here?
There is a general view among market players that a further fall in yields is feasible. Malcolm Charles, Head of Fixed Interest at Investec Asset Management, puts the state of play into perspective. “The SA political scene has gone quiet, we are near the peak in inflation and the global environment is calm,” he says. “The situation is supportive of taking a bit of risk.”
Henk Viljoen, Stanlib Head of Fixed Interest, points to the solid after-inflation real yields to be had on fixed interest assets. At the R186’s current 8.7% yield, the real yield using SA’s year-on-year inflation rate of 6.8% in December is all but 2%. It appears set to go a good deal higher.
“This [6.8%] should be the peak for SA inflation,” notes Stanlib Chief Economist, Kevin Lings. “In 2017, SA inflation is expected to move meaningfully lower to an average of 5.2%, helped by a sharp slowdown in food inflation as well as favourable base effects.”
At 5.2%, bond investors will be pocketing a real return of around 3.5%. “The real return from bond and income funds must be very attractive to a long-term investor,” says Viljoen. As he notes, income funds are a viable alternative for investors wanting to pick up a solid real yield. They also come with far lower risk than bond funds.
While income fund investors give up some yield, it is minimal. “One-year NCDs [negotiable certificates of deposit] from the big four banks are yielding 8.3%,” says Botha. “On three-year NCDs the yield is 8.6%-8.65%.”
The level of risk an investor is willing to shoulder is always a key consideration. Things may be quiet on the SA and global fronts but there are many unknowns. One of the biggest, locally, is the threat of a ratings downgrade. We were spared it in December but still face reviews by the big three rating agencies — Standard & Poor’s (S&P), Moody’s and Fitch — in June and December.
S&P is the rating agency to watch most closely. It has SA’s sovereign credit rating at BBB-with a negative outlook. Just one notch lower and SA government bonds will have non-investment-grade “junk” status.
Also of concern is that S&P has had SA’s sovereign rating on negative watch since December 2015. Under S&P’s rules, within 24 months of the negative outlook being handed down, it has to be resolved — either by switching it to a stable outlook or through a ratings downgrade, explains Botha.
Charles points to another ominous development: SA’s local currency credit downgrade by S&P in December to BBB, two notches above junk status. “About 92% of government debt is in local currency,” says Charles. “The downgrade was a very bad outcome.”
It is the local debt rating that counts when it comes to SA’s continued inclusion in the Citi World Government Bond Index (WGBI). A fall to junk status would preclude SA from inclusion and could see foreigners turn sellers on a grand scale. Also looming large as an unquantifiable potential risk is new US president Donald Trump. “His actions as president are impossible to forecast,” says Botha.
What we do know of Trump is that infrastructure spending of as much as $1trillion is high on his agenda. Much depends on how fast he can get the spending going. “If he gets it going quickly it will mean issuing a lot of debt,” says Viljoen. “It would be very worrying for interest rates.”
What is worrying for US bond yields is also worrying for emerging market yields, SA’s included.
The Trump factor in the outlook for US bond yields even has Bill Gross, a veteran US market player, puzzled. Gross, who manages the US$1.8bn Janus Global Unconstrained Bond Fund, has turned to technical analysis for an answer. In his focus is a downtrend line that began an unbroken descent in the early 1980s when the US 10-year bond yield stood at over 15%. It is now at 2.4% and the trendline is at 2.6%.
In his January market outlook Gross notes: “This is my only forecast for the 10-year in 2017. If 2.6% is broken on the upside — if yields move higher than 2.60% – a secular bear bond market has begun. Watch the 2.6% level.”
It is a level bond traders worldwide will no doubt also be watching.