S.A. government bonds endured a tough second quarter, delivering a negative return of 1.5%. Longer maturity issues were especially weak and sold off heavily alongside the rand, as adverse investor sentiment contributed to increased volatility in the domestic bond market. Despite attractive yields, foreigners have remained net sellers over the last few years as concerns around loadshedding continue to detract from the investment thesis for local currency government bonds. The outlook for the asset class is further constrained by low domestic growth, a deteriorating current account and high levels of debt. Volatility has also increased steadily over the last year as investors attempt to re-price risk in one of the fastest global rate hiking cycles in recent history.
The volatility paradox
While volatility can be a useful measure for assessing the dispersion of realised returns relative to expectations, it’s not especially useful for measuring investment risk. Volatility is a lagging indicator that tends to be low when market prices are rising and higher when market prices are falling. This can actually mask investment risk and feeds into the paradox where high-return, low-volatility assets could actually be contributing the highest investment risk in client portfolios.
This paradox extends further to markets that trade with low liquidity, where a lack of efficient price discovery contributes to low volatility understating tangible investment risk. The South African corporate credit market is a case in point, where backward-looking volatility measures would suggest that investment risk is artificially low because price movements are especially muted. In the absence of adjusting volatility for forward-looking estimates around expected asset returns, volatility is a relatively blunt risk management measure on a standalone basis.
Rising bond market volatility
The graph below shows the volatility of rolling 12-month total returns of the FTSE / JSE All Bond Index (ALBI) as a proxy for the domestic bond market. It also shows the net monthly purchases of South African government bonds by non-resident or foreign investors over the last 10 years.
The trend shows that net selling by foreign investors contributes to higher volatility, with March 2020 providing the best example of extreme volatility following aggressive foreign outflows. Volatility peaked in the second quarter of 2020 when the Reserve Bank intervened to support liquidity in the domestic bond market during the COVID-19-induced global market selloff. After coming down relatively consistently from post-pandemic highs, volatility has been steadily increasing over the last 12 months and has accelerated over the last quarter as foreigners remained net sellers of rand-denominated holdings.
While volatility may provide some indication of market sentiment it provides no useful information about the drivers of market and investment risk. What matters most is disentangling the drivers of volatility and assessing the observed changes in market price relative to fundamentals.
What risks should investors pay attention to in the current cycle?
- Liquidity risk
Both the primary and secondary domestic bond markets for S.A. government bonds typically trade with good liquidity and price discovery. In the primary market, bid cover ratios provide an indication of the appetite for government bonds and allow market participants to gauge investor demand across different debt maturities being issued. In secondary markets, bidoffer spreads provide an indication of the price and yield where buyers and sellers are willing to trade. High (low) spreads indicate buyers and sellers are relatively far apart (close) in terms of what they consider a fair price to trade.
Monitoring liquidity through changes in spreads across these markets provides a better indication of investor demand than simply observing volatility through changes in bond prices or returns.
Liquidity risk can further be monitored by assessing the pool of investors allocating to South African government bonds. Local investors currently account for approximately 75% of the market for local bonds. Foreigners have sold holdings relatively aggressively (from just over 40% to 25%) over the last five years. From a market structure perspective, a less diversified pool of underlying bondholders is a net negative for price discovery and should result in investors demanding a higher liquidity premium to account for a lower ability to negotiate market pricing.
- Credit risk
The risk of default on rand-denominated bonds is often overstated by investors. Governments are highly unlikely to default on debt issued in local currency since they can increase direct or indirect taxes on both individuals or companies or even print money to avoid not meeting obligations. Foreign currency bonds are higher risk, but government has managed that exposure conservatively, with South Africa having relatively low levels of hard currency debt compared to emerging market (EM) peers. The country is, however, somewhat of an outlier across the EM complex in terms of exposure to contingent liabilities from failing state-owned enterprises (SOEs) and parastatals.
South Africa’s challenges around elevated debt to GDP levels and increasing borrowing costs are well documented. Credit rating agencies have reiterated the deterioration in government’s balance sheet and the consequences of debt overhang from continued fiscal slippage. Investors have largely priced in the required credit premium into local bond yields. The change in hard currency debt exposure is important to track, not only on government’s balance sheet but any quasi-government entities with either direct or contingent liability claims on funding support.
- Interest rate risk
Interest rate risk is best measured by duration, which effectively captures the sensitivity of bond prices to changes in interest rates. A good rule of thumb is that a 1% change in interest rates contributes to approximately a 1% change in the price of the bond. There are other factors, but duration has the most meaningful impact. Longer duration bonds typically have higher interest rate sensitivity and experience relatively larger drawdowns than shorter maturity bonds for an equivalent increase in interest rates.
Higher duration does not necessarily mean higher risk. The starting yield and investment horizon are exceedingly important. The key question for investors is whether bond yields provide a sufficiently high margin of safety to compensate for potentially higher interest rates and inflation over their investment horizon. Even with rising interest rates, a long-term investor can still earn the starting yield by holding the bond to maturity and re-investing periodic coupon payments at higher interest rates. The coupon plus re-investment of that coupon is likely to offset the initial capital drawdown for a hold-to-maturity investor. A shortterm investor does not have the benefit of reinvesting coupons for a long enough period to negate the drawdown in price. Higher interest rates in the current economic environment largely incentivise and reward long-term investing, but shorter-term investors could experience permanent capital losses by attempting to time the market.
The graph below shows the implied return on South African government bonds using the 10-year maturity as a proxy.
Yield has historically been the biggest driver of total returns and is usually a good indication of the return investors can expect to earn by holding the bond to maturity. The above graph shows that besides the COVID-19-induced selloff in 2020, current bond valuations are at their most attractive levels since 2014. South African government bonds are currently priced to deliver just under a 5% real return over the next 10 years. This is an especially conservative expectation in that the valuation assumes a 6% inflation expectation at the maximum of the Reserves Bank’s inflation target band. The bank has a target of 4.5% so there’s an embedded margin of safety built into the higher inflation expectation.
Interest rate risk is elevated in the current economic environment with investors weighing up opportunity costs and demanding higher returns on capital for allocations across different regions and asset classes. The higher yields available in local currency bond markets like South Africa, provide an especially cheap entry point into the fixed income opportunity set and sufficiently compensate long-term investors for duration.
Higher bond market volatility is not equivalent to higher investment risk. In the current environment, increased volatility may be the price investors need to pay in the short term to improve their chances of meeting their long-term investment goals. Breaking out investment risk into liquidity, credit and interest rate risk allows investors to better assess the fundamentals being priced into bond yields.
South African government bonds are supported by a relatively predictable stream of rand-denominated cash flows that currently provides a strong yield underpin to expected returns for local investors. At implied real yields of around 5%, local bonds offer a sufficiently high spread above fair value to compensate investors for the risks currently priced into the asset class.
Disentangling volatility from investment risk is exceedingly important to position portfolios to benefit from the bouts of fear and greed that are currently obscuring the fair value of assets.
Unfortunately, the extreme uncertainties evident in the current market environment mean that investors can’t avoid risk. However, risk can be managed by following a long-term fundamental approach that is flexible enough to respond opportunistically to irrational shifts in markets.
Understanding the range of potential outcomes, as well as the reward for risk trade-offs across different asset classes is important for keeping portfolio mandates aligned with long-term investment objectives.