Twelve months ago, investors in South African bonds had good reason to be happy. January 2022 had started on the front foot, the rand was near R14 to the dollar, and bonds were up nicely.
Despite global inflationary pressures, South Africa was doing relatively well with a current account surplus and an inflation rate unusually lower than the US, UK and Europe. After a positive budget speech on 23 February, the outlook was good.
Then on 24 February, Russia invaded Ukraine. That started a chain of events that fanned the existing inflation flames, causing global equities and bonds to fall in unison. The global risk-off sentiment dragged the rand and South African bonds down along with almost all other asset classes.
Over the rest of 2022, local bonds faced a barrage of negative events and eventually their capital value finished the year down 5.5%, which is a large drop for a relatively conservative asset class.
So, despite a bad year for South African bonds, it was still an inflation-beating year for investors in these portfolios. Importantly, this is consistent with our longer-term experience and expectations. A number of managers in this category have navigated through disastrous events like ‘Nenegate’, South Africa’s downgrade to junk status, the Covid pandemic, and the 2022 inflation crisis, but we were still able to generate returns beating cash and inflation every calendar year.
A misunderstood asset class
The reasons for this are quite simple. Firstly, bonds are essentially investments that pay a fixed amount of interest regardless of what happens in the market.
Secondly, by taking advantage of the volatility and investing more into bonds after the capital has fallen and their yields are high, you are able to lock in high forward returns. Last year, during the panic, we bought a lot of bonds when they were offering more than 11% and even 12% at one stage.
Thirdly, bonds in the past have bounced back quicker than other riskier asset classes like equities and property after a drop in value. Bonds behave a bit like a strong rubber band, they tend to fall less and then recover much quicker. This resilience gives us as portfolio managers much greater confidence to buy them into weakness without having to worry about sustained drawdowns.
This is very powerful for investors who are drawing an income and want to avoid drawing down on their capital.
So where are we now?
History shows that the most important determinant of the future return of bonds is the yield at which you buy them. Evidence shows that buying bonds at higher yields not only increases your chances of higher returns but also reduces the chance of low or negative returns.
As an example, in the past if you bought bonds at their current yields (between 11% and 12%), your average return over the next two years would ranged between 13% and 17% per year. That is a very attractive potential return from a relatively low risk asset class, and the kind of return investors hope to get from equities in good years.
Overall South African bonds have many of the characteristics of an ideal investment: they are offering a high, predictable return with lower volatility and limited downside compared to equities and property. When a bad year can still turn out to be a good year, investors should take notice.