Yield to the bond market

The bond market plays an essential function in the modern financial system in that it provides long-term financing to the economy through the issuance of debt securities. The government then makes interest payments on these securities which should reflect the prevailing interest rate environment and provide a level of protection against inflation.

The oil price is one of the key factors to consider when determining the risks associated with bonds as the movement in this price affects growth, inflation and ultimately interest rates. High oil prices increase inflation expectations which push up the yields on bonds.

The global crude oil market is an actively traded and volatile market, driven by global warming, geopolitical risks, supply and demand shocks and quota controls, among others. While the recent rise in energy prices from the escalating Russia-Ukraine war has boosted profits for major energy companies, it has contributed to rising global inflation and worsened the cost-of-living crisis as these high energy prices created additional indirect pressure on food and transport costs.

The front end of the bond curve is more sensitive to inflationary pressures than the long end, because as inflation rises or falls, front-end rates are more likely to go up or down to a greater extent than the long-end yields. As an emerging economy, South Africa’s bond yields have been attractive to global investors hunting for yield compared to some of its emerging market peers like India, Mexico, Turkey, Russia and Brazil.

The reason why SA’s bonds are so attractive in real terms is that it has the steepest bond curve and highest real yields within these emerging markets. Real yield is the return the investor receives after taking into account the inflation rate.

Inflation remains a key factor to consider when investing in bonds. Higher future inflation expectations equal higher yields required by investors. The SA 10-year government bond yield at around 10.20% and inflation at 5.90% means bond investors are earning a real yield of 4.3%, which is quite attractive.

In 2021, our bonds were one of the top performers in fixed income markets around the world. The All Bond Index (ALBI) outperformed the World Government Bond Index (WGBI) by almost 17% over a one-year period. This implies our bonds delivered superior returns compared to other countries.

Moody’s kept the sovereign local and foreign currency credit ratings at Ba2 and changed the outlook from negative to stable. The ratings agency indicated a potential credit rating upgrade if SA makes significant progress in addressing structural growth constraints that strengthens the prospects of reducing government debt. This is in line with the government’s consolidation plans and commitment as tabled in the budget to ‘stabilise’ SA’s debt to around 80% of gross domestic product (GDP) by 2024, which was positive for holders of our local bonds.

The money markets expect the South African Reserve Bank (SARB) to hike interest rates to try and tame inflation. Bond yields and the local currency weakened substantially against the dollar as the US Federal Reserve (Fed) hiked rates. The weakness followed aggressive rate hikes by major central banks and the Fed earlier in May, which raised its policy rate by 50 basis points (bps) in line with market expectations.

Bonds and the weak local currency seem less convinced about the steepness of the future rate-hike cycle priced in the forward curve. The forward curve indicates the direction and level of interest rates. It could be that the market is nervous that US inflation is out of control and that the Fed will hike repetitively and in higher increments of 50 bps going forward. The recent SARB interest rate hike may provide relief to the bond market and support the rand.

Fixed income investments are suitable for investors who want access to cash or capital protection with moderate capital growth. In an investment portfolio, fixed income, firstly, serves to generate income for a portfolio and, secondly, is a good diversification away from more risky investments like equities.

With our investment philosophy and process, we always compare the risk with opportunity in our investments and we follow a valuation-based investing philosophy, meaning we look for instruments we believe have high value but are undervalued by the market. Consistency is key and we believe in the value of diversification. We don’t chase higher interest payments for the sake of it, as we don’t want to shoot the lights out today but be last tomorrow. We want our portfolios’ outcomes to match our clients’ outcomes.

With us, investing is personal, and our measure of success is when we can deliver on client outcomes over the appropriate investment horizons at low levels of risk.

Momentum Investments is part of Momentum Metropolitan Life Limited, an authorised financial services (FSP6406) and registered credit (NCRCP173) provider.