Tow­ers Wat­son As­set Man­ager Re­view

The Star Early Edition - - LABOUR FOCUS - Mei-Chi Liou, port­fo­lio man­ager at FU­TURE­GROWTH AS­SET MAN­AGE­MENT Vic­tor Mpha­phuli, head of bond and in­come funds at STAN­LIB Sean Neeth­ling, credit an­a­lyst at RECM Do in­fla­tion-linked bonds have a role in an or­di­nary bond port­fo­lio? What is your cur­rent v

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.

Newspapers in English

Newspapers from South Africa

© PressReader. All rights reserved.