Investing in bonds
Retirement funds are well placed to take advantage of the higher yields on less liquid bonds, because they are long-term investors for whom the risk of becoming forced sellers is usually very low.
One important difference between bond investments and investing in equities (shares) should be mentioned, because it has implica- tions for the construction of bond portfolios.
When investing in shares, there is always the chance that the share price will fall to zero (as happened to African Bank shares when the bank failed), but there is also the chance of very large gains, because the share price could in theory – and sometimes in practice – rise to mul- tiples of the price at which the shares were bought.
With corporate bond investments, however, there is similarly the risk of complete default (so that the value of the bond falls to zero), but the chance of large gains in value – if interest rates fell very sharply – is much smaller, and there is no real chance that bond prices will double or treble. So the “payoff” for corporate bond investments is skewed towards the downside – a loss of 100 percent of the investment is possible, but the chance of a 100 percent gain is tiny or nil. This means that diversification – spreading your bets across a large number of bonds – is critical for corporate bond investments.
Ten or fifteen years ago, most of the investments held in local bond portfolios were RSA Government and parastatal bonds, and the investment manager’s job was in large part trying to anticipate interestrate movements and how the prices of different bonds would react to these.
Today, investing in corporate bonds and managing credit risk has become a large part of the manager’s job. Taking on increasing amounts of credit exposure (and receiving higher interest rates from the borrowers for doing this) has in fact been a very good way for managers to beat their bond benchmarks, seemingly with little added risk – until the recent First Tech / First Strut and African Bank failures reminded investors that there are no free lunches!
The recent launch by the JSE of credit indices should also make it easier to set better benchmarks for bond portfolios that include significant credit allocations.
The South African bond market has been through a decade of exciting growth and development (and we have not even mentioned fixedincome derivatives, a related area that has also expanded significantly).
Bond and money-market assets will remain a substantial part of retirement fund investment portfolios, and managers’ use of credit instruments will continue to grow in importance. In the rest of this Asset Manager Review, the managers speak for themselves on the role that bonds play in their multi-asset portfolios, and on their current views of the fixed-income markets.
Erich Potgieter and Greg Hatzkilson, Towers Watson