The downward pressure on bond yields was driven by the record level of foreign flows into South African bonds. This was in line with global flows into emerging market bonds in the search for yield, while SA bonds were further aided by their inclusion in the Citigroup World Government Bond Index. Foreign ownership of bonds has grown from 10% in 2007 to a current estimated level of 40%. Given this high level of ownership, it is questionable whether foreign flows can continue to underpin the bull market in bonds going forward, or whether deteriorating fundamentals will begin to push yields higher.
The chart below shows how the average emerging market bond yield (measured on the right axis) has fallen by nearly 2.0% since the beginning of 2012, while the developed market average yield (left axis) was relatively flat over the course of the year.
With both international and South African bonds at record low yield levels, the return potential of this asset class going forward is poor. The chart below shows the yield of the five-year SA bond versus the one-year Jibar rate (a money market proxy).
At the beginning of 2012, investing in the five-year area provided a yield pickup of 1.3% above money market rates. This positive yield spread, combined with a cut in interest rates at the July 2012 MPC meeting, enabled bonds to outperform the money market handsomely over the course of the year. The yield spread has since fallen to below 0.3%, which significantly reduces the potential for bond outperformance over the coming year. Unless one sees the potential for further rate cuts going forward, this meagre yield pickup is not sufficient compensation for the interest rate risk assumed.
While there is a small chance of a further interest rate cut, we do not believe this is likely, given the poor inflation outlook. The level of real interest rates (nominal interest rates minus inflation) in South Africa is well below our emerging market peers, making it difficult for the MPC to justify further rate cuts. We believe there are currently better return opportunities in other asset classes, without the need to take on significant interest rate risk by investing in the bond market.
The mandate of the Nedgroup Investments Flexible Income Fund enables us to take advantage of return opportunities across the fixed income spectrum. The current yield on some of the income alternatives are as follows:
The yield comparison shows that bonds provide little yield enhancement at their current levels and it is our view that other fixed income asset classes present better value from a risk return perspective.
We currently have significant holdings in yield enhanced money market assets and inflation-linked money market assets. We have also taken advantage of opportunities in the credit space, specifically by increasing our exposure to bank bonds with yields of 7.3% to 7.5%. We hold a range of preference shares, primarily exposed to the big four SA banks with yields close to 6% (post-tax). In the alternative asset space, we have also taken on a small exposure to convertible bonds, which have attractive yields plus upside potential.
With nominal bond yields currently at historically low levels against a deteriorating fundamental outlook, we have decided to minimise our exposure to bonds until there is significantly greater value.