While some investors believe bonds shouldn’t have a bulky allocation in the income-generating part of a retirement portfolio, others are optimistic about government bonds, saying a larger allocation to the asset class would stand investors, including retirement funds, in good stead.

By Jaco Visser

The government’s medium-term budget policy statement, or “mini budget”, will be delivered on 1 November and all eyes are on how National Treasury will balance lower tax receipts with a staunch resistance to cut spending.

If the bond market is anything to go by, it seems like investors have made up their minds: the government will struggle to keep to its stated intent of fiscal consolidation.

It is especially on the long side of the bond yield curve (debt with maturities longer than 12 years) that downward price pressure has been building up, keeping yields inflated at attractive real rates.

The elevated yields of longer-dated government bonds are, however, also due to a worldwide scenario where higher inflation is driving higher interest rates.

“The global backdrop continues to dominate,” Nolan Wapenaar, co-chief investment officer at Anchor Capital, tells Today’s Trustee. “Where US yields go, we will follow.”

Conrad Wood, head of fixed income at Aluwani Capital Partners, says higher interest rates around the world were inevitable. “The reason yields are all going up is because there is too much debt and too many bonds being issued. A lot of countries are now experiencing fiscal pressure in paying this debt back.”

In essence, the higher inflation and subsequent interest rates are the fallout of the “excesses of the last decade with [governments’] printing money [as part of] quantitative easing,” Wood says.

The higher subsequent interest rate environment will, however, not fade quickly.
“The risk of rates remaining high for a prolonged period is top of mind,” says Wapenaar. “Expectations of global rate cuts early in 2024 have been pushed toward the end of the year. There is a risk that these are pushed even further into the future.”

Against this global outlook, led by higher-for-longer interest rates in especially the US, domestic interest rates and bond yields will likely remain elevated for a longer period. And that’s thanks to the government’s handling of the fiscus.

That is evident from South African Reserve Bank (SARB) governor Lesetja Kganyago increasingly hawkish stance on interest rates on the domestic front. For instance, he recently swiped at the government’s failure to rein in spending.

Speaking after the SARB’s release of its monetary policy review on October 18, Kganyago said: “Spending pressures are evident in the larger-than-budgeted wage growth this year and the financial needs of struggling state-owned enterprises, among other factors.”

The following day, Statistics SA released the September consumer price index (CPI) figures, which showed annual inflation accelerating to 5.4% from the previous month’s 4.8%. The September figure is almost one percentage point higher than the SARB’s 4.5% unstated target for annual inflation.

Need for “credible action”

The deterioration in the country’s inflation figure is worrying, however, some investment professionals reckon it won’t result in immediate action from the SARB.

“This reading in headline inflation supports the view that the SARB could keep the repo rate steady at their next monetary policy committee meeting in November,” Adriaan Pask, chief investment officer at PSG Wealth, said in a note to clients.

Thus, it turns on the government’s political will to stick to its fiscal consolidation.
“Domestically it is all about the government’s finances,” says Wapenaar. “The government has no choice but to reduce spending as government debt issuance is clearly toward the top end of what the market can absorb and the ability to raise taxes is limited.”

Echoing Kganyago’s stance, Wapenaar says “we need to see credible action toward bringing government finances under control while we address the failing state-owned enterprises.”  
But whether this will actually happen in the medium-term budget policy statement (MTBPS) depends on the politics.

“The message that spending needs to be managed is not a popular one with a number of role-players within South Africa and we are seeing the inevitable push back,” Wapenaar says. “How this plays out will be key for the future of South Africa and the prospects of bonds and the rand.”

Bonds have had a mixed year so far. It is clear from the returns of different maturities that the market doesn’t trust the government’s ability to steer the country through a tough economic environment faced with a heavy public debt burden.

For instance, debt with maturities between one and three years delivered a 5.5% return this year, compared with those falling due in more than 12 years losing investors 1%.

This illustrates how investors are very uncertain about the economic outlook of the country over the long term, demanding higher yields (and paying lower prices) for government debt.

How this affects trustees

But where does this leave retirement funds when they decide how much to allocate to income-type assets, such as bonds and cash?
With yields on longer-dated bonds at around 12%, it seems that investing in them now may not be a bad option.

“Bonds are yielding about CPI plus six percentage points, sometimes more,” says Wapenaar. “This is rather attractive for retirement funds, and we expect that the retirement fund portfolio composition will continue to swing towards domestic bonds and global equities. We think that investors want to remain focused on the belly of the curve and prefer bonds maturing in 2037 or sooner.”

Wood agrees. “South African bonds have held up pretty good over the past year, given the economic circumstances. The yields on government debt, especially longer-dated bonds, are much higher than the [price] returns.”

But, as Wood says, if you take both the price decline in bonds and their yields into consideration, they’ve matched the returns of cash lately. “Bonds’ returns should’ve been higher.”

Going forward, Wapenaar expects the myriad of global and local factors impacting domestic government bonds to offset each other, meaning that South Africa won’t benefit from interest rates starting to decline in the rest of the world.

“Yields are currently about 12%, or 1% a month,” he says. “We think that this is maintained, which is still an attractive proposition for South African investors.”

This raises the issue whether retirement funds, in the light of the looming two-pot system and allowance for members to withdraw from their savings pots, should opt to hold more in high-yielding government debt.

Investors are split on this.

Wapenaar reckons bonds shouldn’t have a bulky allocation in the income-generating part of a retirement portfolio.

“The combination of a loss of [South Africa’s] investment grade credit rating, reduced appetite from abroad and questions about our government is clearly resulting in reduced liquidity on the South African Bond Exchange,” he says.

Foreigners, who normally held a chunky proportion of South Africa’s rand-denominated debt, have sold off their holdings in large quantities over the past year, leaving local investors, especially retirement funds, to mop up the excess supply.

“There is clearly sufficient liquidity for individual funds to reduce holdings or raise cash, but there are limits to what the sector as a whole can sell,” Wapenaar says.

He “would be cautious about overexposure to government bonds within the cash reserves” of retirement funds.

On the other side, Wood is more optimistic about government bonds, saying a larger allocation to the asset class would stand investors, including retirement funds, in good stead.

“In the past, retirement funds have relied on bonds as safe investments with stable returns,” Wood says. “Funds relied on equities to do the heavy lifting in terms of returns.”
But now, he says, “bonds have outperformed South African equities”.

The FTSE/JSE midcap index, consisting of those stocks that generate the bulk of their sales and profits in South Africa, lost 4.3% over the past year. The FTSE/JSE all share index comparatively returned 9.3% – still underwhelming the 12% yield received on longer-dated debt.

Sean Neethling, head of research at Morningstar South Africa, describes the current anomaly in the local market: “South African equities are expected to deliver higher real returns so the spread [difference] over South African bonds is normally positive. While the differential was mostly below average last year, it turned negative in June [this year] suggesting that bonds are especially attractively priced.”

“Invest in bonds”

For Wood, this means one thing.
“Bonds deserve a higher allocation in an investment portfolio now,” Wood says. “If you look through the headwinds, bonds are going to do their traditional job and outperform.”

With the looming implementation of the two-pot system, planned now for March 1, 2025, retirement savers will be allowed to “seed” the savings pot with 10% of their current vested shares up to a maximum of R30 000.

This foresees a large outflow of cash from retirement funds necessitating prudent liquidity planning.
Wood, however, says retirement funds should think twice before liquidating their bond holdings to address the payouts.

“If you have to provide for these cashouts, you may be tempted to choose the more liquid assets in the portfolio,” which include bonds, he says. “It would be a shame if funds sell their bonds and lose out on the opportunity to earn attractive returns. It will be the wrong time to sell bonds to meet liquidity demands.”

And, according to Wood, the bond market is more than liquid enough to handle a large liquidation of bonds to address cashouts.

“The daily turnover in the bond market is about R30bn,” he says. “The local bond market is substantially bigger than the largest estimate for cashouts that I’ve seen.”