In­vest­ing in bonds

The Star Early Edition - - LABOUR FOCUS -

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

Novem­ber 2014

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