Batten down the hatches, because the case for global bonds is not risk-free

THE BEHAVIOUR of the global bond market over the past 11 months is testament to the reality that bonds are not risk-free. Quantitative easing by central banks initially caused unprecedented windfalls that gave savers a false sense of financial wellbeing.

The normalisation of monetary policies and upshot in inflation as a result of supply chain disruptions due to the ripple effects of Covid-19 and the Ukraine/Russia conflict saw the global yield curve, depicted by 10-year government bond yields and corresponding sovereign credit ratings, increase by more than 250 basis points (2.5%) at the high in mid-October since the end of last year.

The pain caused by the shift in the yield curve was excruciating for investors, specifically retirees and contributors to retirement savings plans as the capital loss at that stage, as measured by the net asset value of the iShares Global Government UCITS ETF (exchange traded fund) with the FTSE G7 Government Bond index as benchmark, was more than 25% in terms of US dollar.

Yes, similar to the 26% drawdown in developed market equities as measured by the MSCI World Index in US dollar. Since then, the yield curve shifted about 70 basis points (0.7%) lower, resulting in a gain of nearly 6% in the net asset value of the ETF. In comparison, the MSCI World Index gained 14% in terms of the US dollar. But where to from here?

The current quarter or the first quarter next year will probably herald the start of a new recession worldwide. From the latest “flash” and official purchasing managers’ index (PMI™) data from S&P Global, it is apparent that the contraction in business activity across the private sector in most of the major economies, with India and Brazil the exception, is gaining momentum. The downward spiral is such that US bond market players are anticipating what appears to be a deep recession ahead.

The US yield curve as measured by the US 10-Year Treasury constant maturity bond yield minus the 2-Year Treasury constant maturity bond yield is the most inverted since August 1981.

In the past cycles the US yield curve on average turned negative about two to three quarters before a recession.

This time round it appears that, as in 1981, the lead time will be much shorter. Freightos Limited, a leading global freight booking and payment platform, recently reported that falling demand has pushed port congestion nearly back to normal. Yes, pent up demand has vanished. Furthermore,

China, the locomotive of global economic growth, is taking strain as Covid-19 curbs through mobility restrictions and lockdowns take their toll. Retail sales of consumer goods from January through October this year were up by a paltry 0.5% compared to a year ago.

The labour market worldwide has stabilised as employment growth has stagnated. More and more major companies have already announced layoffs and the trend is likely to intensify. The already cash-strapped consumers are therefore in for tougher times. Falling demand is already leading to price inflation at the factory door moderating. Furthermore, Freightos’s Global Container Freight Index, based on freight rates globally, is down by 77% from a high in September last year.

Further downside is in the offing as the said Index is still 70% higher than the pre-Covid levels, as the shipping industry is countering the fall with cuts in capacity.

Commodity prices are already under pressure. Metal prices as measured by the Economist Metals Index in US dollars are down by 28% since March this year, but still about 17% higher than pre-Covid levels.

The Goldman Sachs Commodity Index lost 23% from its high in March, but is still 40% higher than pre-Covid levels due to the impact of the Ukraine/Russia conflict on food and gas prices.

The Economist Food Index and Nymex Gas futures are down by 21% and 33% from their highs in March, but still up by 37% and 150% respectively from their pre-Covid levels.

Against this backdrop, it is unsurprising that central banks worldwide have suddenly become more dovish and have started to steer away from outsized rate hikes.

I am of the opinion that the peak in the tightening cycle is closer than what most analysts and commentators think as the central banks will want to avoid an overkill of their economies.

With the conflict in Ukraine raging on, rates will probably remain elevated for longer as upside inflation shocks persist. Going back to 2009, history has shown that at best equities perform in line with bonds during downswings whether it be slower growth or recession. Equities start to outperform when indicators such as the PMIs start to gain momentum.

The current food and gas crisis caused by the geopolitical situation in Eastern Europe, however, reminds me of the fallout of the oil crises in 1973 and 1979 that triggered economic recessions worldwide. Those of us who were in the markets in the early 80s will never forget the expensive lessons learned during the 1981/82 recession. The US stock market, as measured by the S&P Composite Index, contracted by 17% from when the US recession started to when the recession ended.

In comparison, the market yield on US Treasury Securities at 10-Year Constant Maturity traded in a tight range between 13.5% and 15%. “This time different” could turn out to be the most expensive phrase. Only time will tell during and after the event.

From the global yield curve, depicted by 10-year government bond yields and corresponding sovereign credit ratings, it is evident that emerging market bonds such as Brazil, Mexico and South Africa offer significantly higher yields than mature market bonds.

But it comes at a price. Key factors such as economic outlook, fiscal position, monetary policy and political situation and outlook play a major role in the sovereign ratings assigned to a country by the ratings agencies.

Whether one agrees with a rating or not doesn’t matter as it is evident that it is priced in by the market.

When investing in global bonds one should be aware that there is often a direct relationship between the trend in bond yields in a country and the latter’s cross currency exchange rates. It is particularly evident in the case of South Africa, where a linear relationship exists between the country’s 10year government bond yields and a G7 constituent-weighted currency index.

The relationship implies that a 100 basis point (1%) jump in the SA 10-year government bond yield will see the rand depreciating by about 13% against a G7 constituent-weighted basket of currencies, while a drop of 100 basis points will result in the rand appreciating by 10%.

If, however, a major event leads to a sell-off in SA 10-year government bonds and the yield overshoots by 200 basis points (2%), the rand could drop by as much as 24%. Higher yields mean lower bond prices and as the impact of a 100 basis point move can be calculated, a capital loss of about 12% is possible on a portfolio consisting of 100% SA 10-year government bonds.

It is, however important to realise that should the global yield curve as defined drops by 100 basis points (1%) capital losses may be incurred in terms of rand as a stronger rand may outweigh positive returns on a portfolio consisting of 100 percent G7 bonds.

The questions I ask myself are: What is the quality of my total interest-bearing portfolio? How am I placed if the proverbial strikes the fan, whether it be localised (South Africa) or globally? Am I so optimistic about South Africa that I am prepared to put all my interest-bearing savings into so-called “junk bonds”, the category South Africa finds itself in?

Yes, I’m battening down the hatches!

To pursue resilience, I need to utilise the current opportunities in the global bond market, not only to benefit from prospective lower bond yields, but also to protect the buying power of my savings in what could be rough times ahead both domestically and globally.