Towers Watson Asset Manager Review
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.