Options in turbulence

As long-term investors, times of turbulence often present attractive investment opportunities.

This is when quality assets, tainted by panic, start to trade at discounts to fair value – and therefore present healthy margins of safety. By applying our process, we can avoid being swayed by short-term noise and recognise the opportunities that fear or uncertainty present.

Emerging markets have sold off significantly this year, amid sharply deteriorating sentiment towards assets and economies that investors perceive to be risky. This has provided the opportunity to buy inflation-linked RSA Bonds (ILBs) – an area previously offering insufficient margin of safety.

ILBs provide a hedge against rising inflation. Inflation erodes buying power and, consequently, the real value of investment returns. Returns must match inflation to keep investors in their current financial position and exceed inflation to leave them better off.

ILBs provide protection against upward inflation shocks. They’re issued with a fixed coupon (annual interest rate) on a principal amount (the amount the bondholder invested) adjusted for inflationary growth.

Consider an ILB issued for R100 with a 3% fixed coupon. If inflation in investment year one is 6%, it brings the bond’s total return to R9: a coupon of R3 (3% of the R100 principal) and principal growth of R6 (6% inflationary adjustment on the R100). If inflation in year two of investment is 10%, the annual return will be R13.78: a coupon of R3.18 (3% of the revised principal amount, R106) and principal growth of R10.60 (10% adjustment to the R106).

ILBs again offer attractive real yields. Prices have fallen along with demand and yields have risen. As such, ILBs with longer-dated maturities are offering real (above-inflation) yields of over 3%, while real yields on shorter-dated ILBs are 2.8%. This is the first time in recent years that these assets have presented a compelling investment case. ILBs have been added to our buy list.

Under this scenario, the fixedrate instruments in our fixed income portfolios should continue to offer real long-term returns. As such, we still see opportunity in SA sovereign bonds, fixed-rate negotiable certificates of deposit, corporate bonds and select stateowned enterprise bonds.

But there’s also a scenario under which inflation and interest rates rise. Here, floating-rate instruments will outperform their fixed-rate counterparts, and ILBs will outperform traditional bonds. To hedge against this, we’ve diversified our holdings by investing in floating-rate instruments, offshore cash and ILBs.

Tyron Green is manager of PSG Income A

Moneyweb

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Almost every financial advisor and pension fund will have a target for their portfolios that’s