Tow­ers Wat­son As­set Man­ager Re­view

The Star Early Edition - - LABOUR FOCUS -

LAST quar­ter we asked: What makes a good in­vest­ment in eq­ui­ties (shares)? Eq­ui­ties, whether listed on the Jo­han­nes­burg Stock Ex­change (JSE) or over­seas, are usu­ally the heart of the multi-as­set-class port­fo­lios fea­tured in our per­for­mance ta­bles and widely used by pen­sion and prov­i­dent funds.

How­ever, re­tire­ment funds in South Africa and in­ter­na­tion­ally have also al­ways been sig­nif­i­cant hold­ers of in­ter­est-bear­ing in­vest­ments – bonds as well as cash de­posits and other money-mar­ket in­stru­ments.

At the end of Septem­ber 2014, the man­agers rep­re­sented in our Global Bal­anced survey cat­e­gory were typ­i­cally hold­ing about 66 per­cent of their port­fo­lios in eq­ui­ties (43 per­cent lo­cal and 23 per­cent off­shore), and about 27 per­cent in lo­cally-held bonds and money-mar­ket in­vest­ments, with the bal­ance in­vested in prop­erty, com­modi­ties such as gold and plat­inum, and for­eign cash and bonds. So in­ter­est-bear­ing in­vest­ments are a sig­nif­i­cant part of th­ese port­fo­lios.

In this ar­ti­cle, we give a brief over­view of the bond land­scape in South Africa, and also dis­cuss the na­ture of bond in­vest­ing with a fo­cus on the risks and po­ten­tial re­wards that go along with it.

In­vest­ing in eq­ui­ties (shares) gives you frac­tional own­er­ship of the business whose shares you hold. This means you are en­ti­tled to a pro­por­tion­ate share of the prof­its of the business, paid out as div­i­dends. By con­trast, if you invest in bonds, you have ac­tu­ally lent money to the business or other en­tity that is­sued the bonds, and you are en­ti­tled to in­ter­est on an agreed ba­sis as well as the even­tual re­pay­ment of the cap­i­tal that was lent to the business.

Com­pa­nies bor­row money to pro­vide work­ing cap­i­tal for their op­er­a­tions and, im­por­tantly, to fi­nance in­vest­ment to grow their busi­nesses. The State is also an ex­tremely im­por­tant bor­rower, to sup­ple­ment tax rev­enues and to fund in­fra­struc­ture in­vest­ment. Paras­tatals – no­tably Eskom – bor­row for the same rea­sons.

His­tor­i­cally, the state was by far the largest is­suer of bonds in South Africa, and found a cap­tive mar­ket for th­ese in the pen­sions in­dus­try, since up to 1989 re­tire­ment funds were re­quired by law to hold at least 53 per­cent of their as­sets in Gov­ern­ment bonds or cash de­posits. Th­ese were years of high in­fla­tion and so th­ese com­pul­sory or “pre­scribed” bond in­vest­ments may not have pro­duced the best re­turns for the in­vestors that held them! In ef­fect, this was a source of cheap fund­ing for the gov­ern­ment of that time.

Com­pa­nies rais­ing fi­nance in those years ei­ther turned to the JSE for eq­uity cap­i­tal, or bor­rowed from their bankers. Up to the end of the 1990s, there was very lit­tle is­suance of cor­po­rate bonds, but the last fif­teen years has seen steady and sig­nif­i­cant growth of the listed bond mar­ket in South Africa.

As of Septem­ber 2014, there was R2.2-tril­lion of debt (bonds) listed on the JSE’s debt mar­ket (for­merly the Bond Ex­change of South Africa), by cur­rent mar­ket value. Of this to­tal, 64 per­cent or R1.4-tril­lion was RSA Gov­ern­ment bonds, and a fur­ther 13 per­cent or almost R300-bil­lion was debt is­sued by paras­tatals (no­tably Eskom, Transnet and SAN­RAL) and other pub­lic-sec­tor bor­row­ers such as the big mu­nic­i­pal­i­ties. The bal­ance, to­talling just over R500-bil­lion, was split be­tween the ma­jor banks and other cor­po­rate bor­row­ers.

As noted ear­lier, own­ing a bond (lend­ing money to the state or to a cor­po­rate bor­rower) en­ti­tles the holder to in­ter­est in­come as well as even­tual re­pay­ment of the cap­i­tal lent. In­ter­est may take var­i­ous forms such as fixed rates (which are set at the time the bond is is­sued and do not change) and “float­ing” rates (which change in line with the repo rate, be­ing the rate at which the Re­serve Bank lends to com­mer­cial banks).

Some bonds (mostly RSA Gov­ern­ment bonds) are “in­fla­tion­linked”, which means that both the in­ter­est paid and the even­tual cap­i­tal re­pay­ment are ad­justed up­wards in line with the in­crease in the Con­sumer Price In­dex. Such bonds are in­creas­ingly used by pen­sion funds, which have li­a­bil­i­ties (such as pen­sions in pay­ment) that in­crease in line with in­fla­tion.

In­vest­ing in RSA Gov­ern­ment bonds pro­tects the in­vestor from one im­por­tant risk as­so­ci­ated with bonds, namely the risk of de­fault by the is­suer (the bor­rower) – when the is­suer fails or is un­able to main­tain the in­ter­est pay­ments and the even­tual re­pay­ment of the cap­i­tal bor­rowed.

Gov­ern­ment bonds are gen­er­ally re­garded as a “safe” in­vest­ment (in this sense), be­cause gov­ern­ments very sel­dom de­fault on their do­mes­tic bor­row­ings – the bonds is­sued in their own na­tional cur­rency. This is be­cause, if all else fails, the Gov­ern­ment can print money in or­der to pay off its debts. Of course, un­lim­ited print­ing of money can lead to run­away in­fla­tion, which is not good for bond­hold­ers, cer­tainly when the bonds are pay­ing a fixed rate of in­ter­est.

By con­trast, the risk of de­fault in the case of bonds is­sued by cor­po­rate bor­row­ers is real, as the fail­ure of African Bank has re­cently re­minded South African in­vestors.

The African Bank saga has also taught in­vestors the les­son that not all cor­po­rate bonds are equal when it comes to the risk of de­fault, known as “credit risk”. For bonds is­sued by a par­tic­u­lar company, the credit risk also de­pends on where the bond ranks in the company’s cap­i­tal struc­ture.

“Se­nior” bonds rank ahead of “sub­or­di­nated” bonds in the queue for re­pay­ment – this means that the as­sets of the company must be used to re­pay the hold­ers of the se­nior bonds be­fore the hold­ers of the sub­or­di­nated bonds are re­paid. If there is not enough money to go round, the sub­or­di­nated bond hold­ers will lose out.

Se­nior bonds may also be “se­cured” or “un­se­cured”. Se­cured bonds are loans that are backed by spe­cific as­sets of the bor­rower, just as a mort­gage bond is backed by a spe­cific prop­erty.

Un­se­cured bonds are just backed by the re­main­ing gen­eral as­sets of the bor­rower’s business, what­ever th­ese may be. So se­cured bonds may be more se­nior than se­nior un­se­cured bonds! If the bor­rower de­faults on the loan, the lender can seize the spe­cific as­sets that were pledged as se­cu­rity. Of course, it is im­por­tant to con­sider the qual­ity of th­ese as­sets when mak­ing the loan.

As well as credit risk, other risks that bond in­vest­ments bring in­clude in­fla­tion risk – for both fixed-rate and float­ing-rate loans, an un­ex­pected rise in in­fla­tion erodes the “real” value of the in­ter­est and cap­i­tal pay­ments. In­fla­tion-linked bonds of­fer pro­tec­tion against this risk.

There is also in­ter­est rate risk – for fixed-rate loans (so-called “nom­i­nal” bonds), a rise in the gen­eral level of in­ter­est rates after the loan has been made will bring an op­por­tu­nity cost for the lender, and will cause the mar­ket price or value of the bond to fall.

For in­stance, imag­ine that I lend some­one money over a five-year pe­riod, at a fixed in­ter­est rate of 8 per­cent per year - in other words I buy a bond with a five-year term pay­ing 8 per­cent per year in­ter­est.

If the gen­eral level of in­ter­est rates rises from 8 per­cent to 10 per­cent per year shortly af­ter­wards, I will feel the pain of a missed op­por­tu­nity – by wait­ing a few weeks, I could have made the same five-year loan and re­ceived 10 per­cent per year in­ter­est in­stead of the 8 per­cent that I am ac­tu­ally re­ceiv­ing. The ef­fect is that the value, or mar­ket price, of my five-year loan or bond pay­ing 8 per­cent in­ter­est must fall, be­cause no one will lend money at 8 per­cent when they could lend at 10 per­cent in­stead.

“Du­ra­tion risk” refers to the fact that longer-dated loans are more sus­cep­ti­ble to losses when in­ter­est rates rise. The value of a loan pay­ing 8 per­cent but re­payable in one year will fall by far less, if in­ter­est rates rise to 10 per­cent per year, than a loan also pay­ing 8 per­cent but re­payable only after ten years.

Of course for th­ese risks, there is another side, which is the pos­si­bil­ity of higher re­turns if the op­po­site sce­nario un­folds. If in­fla­tion falls rather than rises un­ex­pect­edly, or if in­ter­est rates fall, then the value of the loan re­pay­ments will be higher than an­tic­i­pated. The mar­ket price of the bond may rise, en­abling the bond­holder to sell it at a profit.

There are fur­ther risks as­so­ci­ated par­tic­u­larly with lend­ing to cor­po­rate bor­row­ers, where there is the gen­eral risk of de­fault. Even float­ing-rate loans (which are not re­ally vul­ner­a­ble to in­ter­est-rate risk) are sus­cep­ti­ble to term risk – lend­ing money for ten years must be riskier than lend­ing it on the same terms for only one or two years, as there is more time for things to go wrong in the bor­rower’s business and thus a higher chance of de­fault.

Log­i­cally, the lender should seek pro­tec­tion against this by ask­ing for a higher in­ter­est rate on a longert­erm loan.

Another im­por­tant risk faced by bond in­vestors is liq­uid­ity risk. While liq­uid­ity (turnover) in RSA gov­ern­ment bonds is very good (over R20-bil­lion worth of th­ese bonds trades daily), the liq­uid­ity of most cor­po­rate bonds is very low. This means there is a real risk that an in­vestor will take a loss if he or she be­comes a forced seller of a cor­po­rate bond in­vest­ment.

Again, in­vestors should seek com­pen­sa­tion for liq­uid­ity risk by ask­ing for higher in­ter­est rates for less liq­uid bonds. The higher rates that the mar­ket charges cor­po­rate bor­row­ers (com­pared with the rates on equiv­a­lent RSA Gov­ern­ment bonds) are com­pen­sa­tion for both credit (or de­fault) risk and liq­uid­ity risk.

Erich Pot­gi­eter and Greg Hatzk­il­son.

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