Bonds lose their low-risk appeal

Investors should be aware that the South African bond market is not as low-risk as it might once have been and could be in for further losses, according to a portfolio manager.

JP du Plessis, fixed income portfolio manager at Prescient Investment Management, says bonds have long been regarded as a safe-haven investment, but now investors may need to consider alternatives if they have a low appetite for risk.

He says bond markets had significant losses this past quarter but the risks remain. The SA Bond Index was down 2.27 percent (ProfileData).

The sensitivity of bonds to large losses has been increasing in the past few years because yields have gone ever lower and because National Treasury has been issuing new bonds with a bias towards longer-dated bonds, which has gradually increased the duration (period to maturity) of the index, Du Plessis says.

He says that during this past quarter, foreigners sold South African bonds “significantly” – to the value of R10 billion – after the United States Federal Reserve indicated it would consider tapering off its quantitative easing programme.

But, he says, foreigners remain net buyers of bonds for the year to date and they own bonds and equities worth 50 percent of South Africa’s gross domestic product. Du Plessis believes this ownership is heavily skewed in favour of bonds.

Currently, real (after-inflation) US bond yields are negative when the long-term after-inflation average is closer to three percent.

The US 10-year bond yields are currently 2.5 percent, while the South African 10-year bond yields are 7.65 percent. The difference in these yields has attracted foreign investors to local bonds, but the difference has to be sufficient to compensate for the additional South African government credit risk and the currency risk.

If interest rates rise in the US as a result of the tapering off of monetary stimulus there, foreigners could sell off their holdings of South African bonds even further, resulting in losses in bond portfolios, he says.

Du Plessis says investors are increasingly concerned that international ratings agencies could downgrade South Africa as a result of the falling rand and its budget and current account deficits (from spending exceeding earnings and imports exceeding exports). The deficits also put more pressure on the rand.

The local bond market has benefited from South Africa being included in the World Government Bond Index, and while Du Plessis believes that being removed from the index is not an imminent risk, he says the risk is building.