Time to take interest in bonds
• Interest rates are likely to start falling in 2024, with the potential for equity-like total returns for bonds
When investors contemplate market crashes or bear markets, the narrative is typically about the precipitous fall in stock market values. However, 2023 has seen one of the worst bear markets in history, but instead of stock markets collapsing it has been global bond markets.
This is out of character for the asset class, which is considered to be among those with the lowest risk profile. Importantly, the global bond market capitalisation is significantly larger than the world’s stock market capitalisation. The health of bond markets is vitally important to the functioning of capital markets.
Central to this paradigm shift of higher interest rates are the actions of central banks, whose policies have come under scrutiny as economic and financial principles have begun to exert their influence. Since the global financial crisis in 2008-09, central banks have kept an ultra-low interest rate policy coupled with bouts of quantitative easing and enormous increases in money supply during the Covid-19 pandemic. At the peak of central bank stimulus, Japanese and EU bonds traded at negative yields, indicating that investors would pay these governments to safeguard their capital.
High prices and exceedingly low yields characterised bond markets over the past decade, reflecting the inverse relationship between bond prices and yields. This created an unfavourable asymmetric return profile in a bond market context, setting up investors for negligible returns while shouldering significant capital risk. The status quo persisted for some time, and only since inflation spiked in the past two years have central banks been forced to increase interest rates to combat inflation.
The increase in interest rates has been one of the fastest raterising cycles since the 1980s. As such, the price of bonds and other asset classes sensitive to interest rate changes have fallen dramatically, while their yields have increased. This has resulted in bond investors taking significant capital losses.
Global interest rates, including those in SA, have
HIGH PRICES AND EXCEEDINGLY LOW YIELDS CHARACTERISED BOND MARKETS OVER THE PAST DECADE
reached 15-year highs. This escalation increases borrowing costs for governments, businesses and consumers. Using the 10-year government bond benchmark rates as a reference, US bond yields hover just above 4.5%, while SA benchmark rates exceed 10%. The global aggregate bond index, a proxy for global bonds, has fallen by more than 20% from its 2020 peak.
Longer-dated bonds exhibit even greater sensitivity to interest rate fluctuations, with the long-dated iShares 20+ Year Treasury ETF witnessing a decline of about 45% from its 2020 high, a noteworthy departure from the traditionally perceived safety of US treasuries.
Higher interest rates are an impediment to economic growth and various asset classes. They are painful but necessary, as the pain of higher rates is usually temporary. Inflation is far more enduring and devastating, especially for consumers whose incomes rarely recover their purchasing power lost to inflation.
The global investment environment has changed dramatically, but with the seismic shift in interest rates, opportunities have arisen for investors. The trajectory of inflation across developed and emerging markets has moderated. Inflation is declining towards central banks’ target levels, and the probability is high that interest rates have peaked or at least are close to their peak for the current hiking cycle.
The peak of the interest rate cycle has created opportunities for various investors. Investors seeking lower-volatility investments with positive real yields (the interest rate less the inflation rate) are now spoilt for choice across the bond and money market spectrum in both a global and SA context.
SA government bond investors can achieve yields of more than 6% above inflation, while real rates in the US are closer to 1.5% above the current US inflation rate.
This can also be achieved with a margin of safety given that interest rates have peaked and further pressure on bond prices has abated.
The current yield environment further provides a tactical investment opportunity whereby investors can collect high yields while potentially benefiting from capital appreciation once interest rates begin to fall.
The bond market is now pricing in the first US interest rate cut in June 2024, with SA likely to follow suit. This set-up could produce equity-like total returns for bond investors.
Investors can also explore opportunities in assets that act as bond proxies, whose values have also plummeted in conjunction with rising interest rates. Sectors such as real estate stand out, where listed real estate values have fallen and their dividend yields have spiked to historically high levels. As the interest rate outlook improves, listed real estate values are set to recover.
Similarly, preference shares are likely to react positively to moderating interest rates and disinflation.
Bond markets historically were solely the realm of institutional investors that could deploy substantial capital that would allow them to access the large minimum requirement to buy individual bonds or shorter-term money market instruments.
But financial markets have evolved, and many highyielding securities are now available within a retail JSE or global investment account.
On the JSE, a wide array of SA bond exchange traded funds (ETFs) are available, with variations in their portfolio composition. Access to global bonds via the JSE is also simple, with a couple of ETFs easily accessible. Global trading platforms are laden with bond and other fixed-income ETFs or managed funds, with varying composition, duration and regional exposure. Individual fixed-income securities are available but do come with minimum investment requirements.
Our conviction remains that equities are the primary vehicle for wealth creation over the long term. However, there is merit to incorporating highyielding investments into portfolios, particularly when optimising for specific income or risk requirements.