Bond funds now star performers, but where to from here?
After a protracted bull market (lasting many years) in South African bonds, the bear once again made an appearance early in 2006. However, this asset class did a spectacular about-turn in July 2008. Money-market funds were the only place to hide after the equity market took a turn for the worse in mid-2007 (with the exception of mining and resources shares, which only commenced their downward trend a year later). However, since mid-2008, bond funds have suddenly become the star performers.
Graph A shows the average performance of the various Association of Collective Investments (ACI) domestic fixed-interest sectors over the year ended 30 June 2008, whereas Graph B shows the performance of these sectors from 30 June 2008 to date (20 January 2009). Where bond funds were the worst-performing funds up to 30 June 2008, they are now the star performers with an average return of 18,6% for the period 30 June 2008 to date.
What is very evident in the returns in Graph B is the fact that the sharp turnaround in the bond market caught most flexible fixed-interest managers (who can change the composition of their portfolios aggressively in accordance with their views on prospects for the fixed-interest market) by surprise. There are a number of reasons for this. Firstly, Investec’s announcement that the South African inflation rate was overstated was a complete surprise. Secondly, many market players were of the opinion that the global financial crisis would not affect the South African economy to the extent that is now evident, and thirdly, many did not expect domestic inflation to come down as swiftly as it has.
But perhaps the most important question now is, what are the prospects for the bond market going forward, and should investors be moving from the money market into bond funds now? The answer is an emphatic no. In my opinion, the bond market (both domestic and international) is already discounting a very dismal economic scenario and more short-term interest rate cuts by the South African Reserve Bank.
The rand remains a spoke in the wheel for further rate cuts. We still have a number of threats that could put a dampener on further rate cuts: Firstly, any more shocks in global financial markets will result in renewed risk aversion and a weaker rand; secondly, our large current account deficit continues to deter foreign investors and, thirdly, our political situation is not helping to induce confidence.
Arno Lawrenz, chief investment officer of boutique fixed-interest asset manager Atlantic Asset Management, concurs with my view. “We have increased our exposure to short-dated bonds but remain wary of currency risks in this global risk-averse market,” says Lawrenz. He adds: “A marked increase in government bond issuance due to a future shift to a fiscal deficit, as well as deteriorating government revenue collection, should put upward pressure on bond yields, particularly at the long end, resulting in curve normalisation and capital losses.”
My advice to investors is to stick to the flexible fixed-interest funds, where the manager has the freedom to change the composition of the portfolio in accordance with market conditions. A cautious strategy towards fixed-interest funds is definitely warranted at this stage.
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