Towers Watson Asset Manager Review
Credit instruments (lending to banks, parastatals and other corporate borrowers) have become a much larger part of bond portfolios over the last 10 years or so. What are the current drivers of the non-government bond market, and what is your current view of the investment case for credit? Has the failure of African Bank had an effect on the market?
“Credit domestically has performed very well in a low-yield environment and our view is that valuation is probably a little overdone (spreads too tight) and macroeconomic headwinds are building, which may result in increasing credit risk in general.”
Wood says the African Bank failure has been a dramatic event for domestic credit investors, particularly as defaults in the local fixed-income market have been very rare. By definition, as the market develops and expands, defaults will occur more frequently.
“However, we would emphasise that failures of investment grade institutions (by far the dominant composition of the local credit market) are still highly unlikely events, which should not dramatically impact a well-diversified credit portfolio or negate the overall risk premium earned by investors from their total credit exposure over time.
“African Bank will shake up the local credit market for a while, but both borrowers and lenders will likely return as developed capital markets are essential in facilitating growth and investment,” says Wood.
says credit has grown from a relatively unknown asset class to what it is today.
“Indeed the South African credit market is small in relation to international markets and we expect this sector to continue to grow in the future.
“Investing in credit allows investors to access higher bond returns, however, it is important to remember that this is not without risk.”
Liou says that because of this risk, it is important that credit investors are adequately compensated for the risks that they are taking. One is effectively lending to a company and should therefore have a view on the sustainability and ability of that company to repay the loans – as such it is important to select an asset manager that has the skill and the capacity (a team of dedicated credit analysts) to make such detailed decisions.
“Defaults within the credit market are a reality, and investors should realise that when they assign a credit rating to an instrument, they are functionally assigning a probability of default to the issuer.
“The impact of a default within the portfolio will be determined by the following factors: the size of the investment in relation to the rest of the portfolio, whether security and other protections were negotiated, whether the right price (interest rate) was charged for the risk and how the asset manager deals with the default when it happens,” says Liou.
says credit has become an important component of bond portfolios over the past year because of the attractiveness of their yields compared to government bonds.
“One of the main reasons we invest in credit bonds is because you can earn an additional spread, but the return has to be commensurate with the risk undertaken after a detailed credit risk analysis.
“In the current bond environment, government bond yields across the globe have come down to multi year lows because of quantitative easing and continued monetary accommodation in developed markets.
“As a result, the returns that one would get on government bonds alone are lower than in the past. It makes sense for investors to switch some of their government bond investments into credit bonds after consideration of all risk measures, because of the higher yields they offer,” says Mphaphuli.
He says the failure of African Bank has highlighted the following issues:
Corporate bonds in SA are largely illiquid and investors will demand a higher spread or premium for credit.
It reemphasises the need for diversification in a portfolio.
Over time, investors will spend a lot of time placing more emphasis on qualitative factors, not just the company’s balance sheets and/or capital adequacy ratios among other numbers. For example, there will be a much deeper assessment of management.
says low yields on South African government bonds have resulted in investors reaching for yield by substituting towards ‘riskier’ corporate credit.
“The supply and demand fundamentals still make corporate credit an expensive alternative based on our valuation of the asset class. Locally we have a relatively limited pool of corporates issuing bonds with strong demand from institutional fund managers.
“The outcome of low supply and high demand is tighter credit spreads and starting yields which do not compensate investors for the risk of default. The investment case for domestic corporate bonds is further weakened by a lack of liquidity in the secondary market.
“This was evidenced by the absence of trading in domestic African Bank (ABIL) debt ahead of the bank being placed under curatorship,” says Neethling.
He says prior to the failure of ABIIL issuance was regularly oversubscribed and corporates could access relatively cheap funding from the market. Declining issuance volumes and widening spreads in both primary and secondary trading, and across a number of corporates, would suggest that the ABIL fallout has re-priced the market to a certain extent.
“The market correction is still, however, not significant enough to make corporate credit a compelling investment for our balanced fund clients,” says Neethling.
says given the merits of a broad-based portfolio construction process that seeks to create diversity and opportunity, he definitely thinks that inflation-linked bonds (ILBs) have a role in an ordinary bond portfolio.
“If managed appropriately, they will enhance the ability to generate active return, as well as provide a more defensive profile for a bond portfolio in a sharply rising inflation environment, without unduly increasing portfolio volatility,” says Wood.
“Inflation-linked bonds have had a phenomenal run in the current environment of financial repression. In our view, inflation would need to be substantially above the 6% upper limit of the target band for a protracted period of time to justify the current valuation level priced by ILBs.
“In a benign environment, with inflation declining globally, we prefer being in nominal bonds relative to ILBs as our inflation expectations are lower than that priced in by the yield differential between the two.
“In addition, with interest rates rising and further repo rate hikes (albeit moderate) still to come, floating rate bonds look set to outperform both nominal and ILBs, giving investors the best risk-adjusted returns going into 2015,” adds Wood.
says inflation linkers can be great investments but, as with all investments, it depends on the price you pay.
“In 2010/2011 we were keen buyers of inflation-linked bonds as the real yield was attractive at around 2.5%. The yields subsequently rallied to a point where we thought they were overvalued and we sold all our linkers in 2013.
“The real yields are now around 1.6% to 1.7%, which does not offer much value. However, in saying that, we don’t see much value in fixed rate bonds either, especially those in the middle area of the yield curve.
“This is why we currently have a preference for floating rate assets,” says Lapping.
says inflation-linked bonds have an important role in an ordinary bond portfolio in that they provide diversification and protection from unexpected spikes in inflation. They are less volatile than most other asset classes, with a beta of around 0.3 to fixed rate nominal bonds.
“However, recently we have seen that in extreme bond market sell-offs, inflation-linked bonds can move on a one-to-one basis with nominal bonds. Issuance has increased, which has resulted in better liquidity, but still remains quite limited especially in the corporate inflation-linked bond space.
“Inflation-linked bonds in the shorter end of the curve (out to about 10 years) look fairly priced when compared to nominal bonds, but those further out on the curve are starting to look expensive.
“We believe nominal bonds are around fair value, given the current inflation outlook, and floating-rate notes should perform well in the current rising rate environment,” says Van Pallander. says the company groups potential returns in a bond portfolio into three broad categories: duration (returns from taking interest rate risk), credit (returns from taking non-government credit risk) and relative value (returns from relatively well priced, similarly risked assets).
“Investing in inflation-linked bonds (ILBs) sits within our relative value process, as an ILB has similar risk attributes to a nominal bond, except that its returns are a function of realised inflation (the higher realised inflation the more attractive the relative return of an ILB to a nominal bond).
“This inflation protection, providing it is relatively well priced, can therefore be a valuable contributor to an ordinary bond portfolio.
“The best way to think of the relative pricing of an ILB versus a nominal bond is to look at break-even inflation. Just like a nominal bond represents the market's expectation of nominal interest rates, an ILB represents the market's expectation of future inflation rates, which is termed break-even inflation.
“The term derives from what inflation needs to realise for the returns of a nominal bond and ILB to break even. Currently, ILBs are discounting a decent drop on CPI inflation over the next year, in line with our own in-house inflation forecasts.
“We, therefore, think that ILBs are fairly valued and will look to increase our exposure to them if they cheapen from current levels,” says Kent.
He reports that due to this forecast drop in inflation Investec believes that the market's current pricing of multiple SARB rate hikes is too pessimistic.
“The combination of inflation remaining contained over the next year and weak growth will allow the SARB to keep rates on hold for the foreseeable future. We therefore favour bonds with more sensitivity to SARB inaction, and as a result have concentrated our portfolios in shorter dated fixed-rate bonds.
“Furthermore, while we believe that National Treasury has taken a courageous fiscal step in the right direction in the latest MTBPS, the fact remains that they will need to continue to borrow in the longer end of the nominal fixed-rate bond curve and we are underweight this part of the curve as a result,” says Kent.
says yes they do, but one will have to look at the benchmark they are measured against. However, for a balanced fund, it can be an additional source of diversification.
“Over the last few months, we have had a situation where the differential between nominal and inflation linked bonds was widening, which made inflation linked bonds look more expensive, but given the recent move in nominal bond yields (with inflation linked bonds relatively unchanged), which have recently come down by close to 40 basis points, it does create an environment in which inflation linked bonds could be attractive in the short term,” says Mphaphuli. Daphne Botha, portfolio manager & head: risk management at FUTUREGROWTH ASSET MANAGEMENTsays the use of inflation linked bonds within a nominal bond portfolio comes down to a fixed income asset allocation decision between cash, ILBs, nominal bonds, credit and some players in the market will even add listed property to this mix.
“So the investment decision is about relative value between the asset classes and right now, in general, inflation linked bonds appear expensive relative to nominal bonds, especially long-dated inflation linked bonds.
“One can also use inflation linked bonds as an inflation hedge (hedge against an upward inflation surprise) in a nominal bond fund, especially in periods where there is huge uncertainty about the inflation outlook.”
Botha says assuming you have an unconstrained mandate the best fixed income asset class would be longdated fixed rate bonds.
“Floating rate bonds would only be preferred relative to short dated (0-3 years) fixed rate bonds as there is a high probability of further repo rate increases.
“Repo rate movements affect the 03 year nominal bond term bucket most,” says Botha.
says inflation-linked bonds certainly do have a place in bond portfolios, however, they are often misunderstood. While the yield is linked to inflation, rising real yields will still have a negative impact on the capital value of the investment.
“Consequently, these securities are still exposed to interest rate risk, given that this is the tool used to address the inflationary environment. Our current view is that inflation-linked bonds are somewhat expensive, and we have no exposure here,” says Newell. says given the right circumstances, inflation-linked bonds could provide valuable diversification and protection against inflation – a key risk facing ordinary (fixed rate) bonds, particularly at long durations.
“At current levels we don’t see a lot of value in inflation linkers, given the relatively high differential in yields between nominal and equivalent inflation linkers (implied breakeven inflation) and the high probability that inflation has peaked for the time being, which suggests to us that nominal bonds (particularly longer dated ones) are offering more value on a relative basis.
“Floating-rate bonds can be a compelling alternative to cash as they possess no (or very little) interest rate risk.
“At the moment, we think that current yields are pricing in a sufficient allowance for rate increases and so don’t find a lot of value in floating-rate bonds relative to nominal bonds.
“That said, they can provide investors with access desirable credit exposure without taking on interest rate risk and so can be useful building blocks in a portfolio,” says Floor.