SA Bonds: Diversification with higher-than-usual returns

Bonds might seem to be a ‘boring’ investment, particularly when compared to equities which are always in the news, but they traditionally have two key roles to play in a portfolio – reducing risk and delivering steady (if unexciting) income. Importantly, in the current market conditions in South Africa government bonds are offering unusually compelling double-digit yields, nearly comparable to those typical of equities. This means that investors have the additional benefit of earning relatively high returns without incurring equity-like risk.

Risk versus returns

The traditional rule of thumb is that the higher the potential return for an investment, the higher the potential risk. For example, when you invest in equities, which are on the higher end of the risk-return spectrum, over time you’re likely to receive better returns compared to other asset classes, but with this potential comes significantly more volatility – investors have to weather temporary downturns with the upturns to reap the eventual rewards.

Bonds are a diversifying asset that can lower risk within a portfolio and protect the downside because their valuations generally respond differently than equities, listed property and cash in various market conditions.

With fixed-rate (nominal) bonds there is a set return (a fixed rate of interest, or coupon) that investors are paid at regular, predetermined intervals over time (usually semi-annually), and capital is returned fully intact at the end of the term. This makes for a steady income stream which, if held to maturity, history has shown is very likely to beat inflation over time. It’s only in unusual circumstances that losses can occur, such as the issuer becoming insolvent and not being able to fulfil their repayment obligations.

This does not mean that they are without risks, however. One of these is inflation: if interest rates are very low and/or inflation is rising, you may not receive an adequate above-inflation (real) return. The best examples of this occurred most recently in developed economies like Europe, where during and some time after the Covid pandemic government bonds offered negative interest rates on both a nominal and real return basis.

Now, however, with global central banks having raised interest rates aggressively over the past 15 months or so, there are no longer any bonds with negative interest rates. Inflation-linked bonds (ILBs) eliminate inflation risk by automatically adjusting their interest rate paid in line with the latest inflation rate. As would be expected, ILBs from the same issuer would generally offer lower returns over time than their nominal bond equivalents due to the lower risk involved.

Another risk is that the bond issuer could default, which is termed credit risk. However, instances of default are rare, particularly for government bonds. Credit risk is measured by the global credit rating agencies like S&P Global, Fitch and Moody’s, which assign credit ratings measuring a bond issuer’s likelihood of default. The best investment managers like M&G Investments have their own credit analyst teams that closely analyse the ability of companies to repay before investing in their corporate bonds, giving them a deep understanding of the companies and credit risk involved.

Interest rate risk is a third type of risk associated with bonds. This happens when, in a rising interest rate environment, new bonds are issued offering higher interest rates for the same risk already being assumed by the investor, meaning that the investor is foregoing higher returns. This can undermine existing bonds’ value in the market, but doesn’t impact the return for buy-and-hold investors. Floating-rate notes are a type of bond often issued by companies where the interest rate adjusts in line with changes in prevailing central bank rates, thereby eliminating interest rate risk.

Attractive yields on SA government bonds

Currently, investors are approaching SA assets with caution due to a number of factors, which include low local growth prospects, loadshedding, weaker government finances, the grey-listing by global financial watchdog FATF earlier this year, and elevated geopolitical risks from the government’s perceived support of Russia. Reflecting this higher risk, yields on SA government bonds rose significantly in April and May, with 10-year bonds touching an extremely high 11.9% before recovering somewhat in June. Still, 10-year bonds (as measured by the benchmark R2032 bond) are currently yielding around 11.3%, which translates into a real return of around 6.3% (when taking into account South Africa’s long-term average inflation of around 5%). Compare this to the 3% p.a. long-term real return M&G Investments would normally expect from SA bonds and the 7% p.a. real return expected from SA equities – on a relative basis bonds make for a compelling investment case.

While we certainly acknowledge the higher-risk environment for South African assets, we believe the current level of SA bond yields is already pricing in all of the above factors, and also reflecting excessive investor pessimism. The market, for example, is pricing in expectations of long-term inflation at levels well above the SA Reserve Bank’s 3-6% target band, an outcome with a very low probability, in our view. As such, yields should offer a healthy margin of safety for investors.

Investing in bonds with M&G Investments

At M&G Investments we hold bonds across a range of our multi-asset and fixed-income portfolios. Based on our view of the attractiveness of our local bonds currently, our multi-asset funds like the M&G Balanced and Inflation Plus Funds are overweight in these assets.

Meanwhile, our lower-risk funds such as the M&G Income Fund make exclusive use of shorter-dated bonds and other fixed income instruments with lower yields, leading to more consistent returns. The M&G Bond Fund invests in a diversified range of government and corporate bonds with longer dates with the aim of producing a higher level of income at slightly higher risk. Try our Fund Selector tool to find out which of our funds are best suited to your investment needs.

To learn more about bond basics, see our Guide to Investing. And for more information or to invest, please contact our Client Services Team on 0860 105 775 or email us at info@mandg.co.za.