January 29, 2004

The year 2003 will be remembered as one where the fundamental drivers of bond yields all contributed to a remarkable bull market.

The currency strengthened dramatically, while inflation at both producer and consumer levels slumped to historic lows.

Not to be outdone, the Reserve Bank reduced its repo rate by 550 basis points, a move that reflected confidence in its target of 3 to 6 percent on consumer inflation excluding mortgages being met.

Local holders of a portfolio of government bonds would have seen a return of 18.2 percent, beating both equities (16.1 percent) and cash (13 percent) hands down.

The advent of inflation targeting should result in lower and more stable long-term interest rates than has been the case historically. Interest rate volatility allows managers to outperform by taking the correct view on rates.

When a manager believes interest rates will decline by more than the market is discounting, he or she can buy more longer term paper than the average market portfolio holds.

This longer term paper provides greater capital gain when rates decline and the manager outperforms.

Stability of rates, in particular, means that fixed-interest managers will find it extremely difficult to outperform the market.

How then are fixed-interest managers expected to obtain additional yield for their investors?

In the past, the government has been the only noteworthy supplier of tradable debt instruments. Years of fiscal prudence, however, have seen a reduction in the supply of fresh paper to the market.

During this time, the corporate debt market has emerged from its infancy. In 2003, 25 corporate issues totalling R60 billion came to market, representing 13 percent of all new debt issues.

This trend follows that of the US, where bond finance exceeds bank loans as a source of corporate funding, and should result in deeper and more liquid capital markets here as it matures. 

The emergence of the corporate bond market provides fixed-interest managers with an opportunity to earn higher yields than those offered on government debt. This is because South African government debt is assumed to be risk free to local investors as it has the power to raise taxes or print money to meet its obligations.

Corporate issuers need to provide a higher return to investors to compensate for the risk their loan will not be repaid.

The question is what level of additional return must be offered to entice investors to lend?

Despite the growth in corporate debt issuance, the local market lacks a long-term history from which one can calculate the probability of default. Studies in the US show that an instrument rated AA has a 0.12 percent probability of default and a BBB instrument, which is still investment grade, has a 2 percent probability of default in any one year.

This is not an insignificant risk if a manager had all its money invested in one asset, but prudent managers can diversify this risk by spreading their money over a variety of issuers of different credit quality, including risk-free government bonds.

In short, the excess return of fixed-interest performance has traditionally been derived from the active management of interest rates and yield curve positions. This should become more difficult to achieve in an environment of stable interest rates.

Portfolios managed with smaller interest rate bets relative to the benchmark will produce more consistent returns since managers can rarely call right repeatedly.

The key to consistent returns is to purchase suitable higher-yielding debt instruments to provide outperformance. These should be included in a diversified portfolio to minimise the risks posed by an individual instrument defaulting.

Suhail Suleman is a fixed-interest credit analyst and Pranay Chagan is the fixed-interest business development manager at Futuregrowth Asset Management