SHARE

Generally, for most investors, fixed-income investing lacks the allure of equities. The growth rate of stocks, dividend payments and earnings growth are attractive features for investors and the performance of their stock holdings.

Fixed-income investing has proven to hold much stability and this very complex asset class creates a strong foundation in the investment process that includes understanding risks and opportunities, using a robust diligence and credit review process. This allows us to take advantage of favourable opportunities, as well as navigate through a volatile, uncertain, complex and ambiguous (VUCA) world.

The fixed-income asset class makes-up an important constituent of a well-managed and diversified investment portfolio. The most common type of fixed-income instruments are cash; bonds and credit. They broadly focus on the preservation of capital and income and pay a fixed interest and dividend payment until maturity date, with the principal paid at maturity. The aim of this type of investment strategy is to provide a steady stream of income with less risk than equity investing. Unlike equities that may pay no cash flows to investors the payments of a fixed-income security are known in advance.

Examples of cash type instruments are money market instruments, T-Bills, etc... Their aim is to preserve capital by investing in short-term (less than 13 month) securities and highly liquid short-term debt instruments and are very secure.  It is broadly represented by the IB Money Market benchmark.

A bond is an obligation or loan made by an investor to an issuer. They are mostly comprised of Treasury, Government, Corporate Bonds, etc….and can have various maturities, principals

and credit ratings and broadly represented by the JSE All Bond Index (ALBI). 

The issuer promises to repay the principal on a fixed maturity date and to make the scheduled interest payments. Whilst interest rates and bond prices move in opposite directions, bond markets are bullish when interest rates are low or falling. The benefits of having a bond to a portfolio are diversification, lower risk and a level of stability.

Credit instruments provides an additional source of low-volatility income. Generally a good credit mix, may include a combination of both government and corporate bonds and debt instruments that provide inflation-beating returns. This can be broadly represented by the JIBAR 3m benchmark. While the credit market is generally expensive, smaller funds can access cheaper sources of credit in the secondary market. These instruments are the first to react during periods of market volatility i.e. asset quality and demand falling and spreads between corporate and bank instruments widening, due to higher perceived risks for corporate paper.

Throughout history, long-term equity returns have been significantly higher than fixed-income returns, and nobody knows when this might end. This is illustrated in the Returns graph below of the JSE All Share Index relative to the fixed income instruments since 2000.

 

Source: Morningstar (end Nov-21)

 

As a result, many investors focus more on the risk of their equity investments.

Since the beginning of the twentieth century (2000), there have been major events that have had a direct impact on financial markets, i.e.:

·       2000/01: Dot Com Bubble

·       2001: 9/11 Terror attacks

·       2003: SARS (epidemic) outbreak in Asia (China)

·       2008/09: Global financial crisis (GFC)

·       2011: EU Sovereign debt crisis

·       2018: Tariff hikes, US/China Trade War

·       2020: COVID-19 declared a pandemic by the World Health Organisation (WHO)

Over this period, the returns from the JSE All Share Index have outperformed the returns from the aforementioned fixed income instruments, while the Sharpe Ratio (Risk/Return) illustrates that these instruments outperformed the All Share Index through periods of market volatility.

The graph below illustrates the Sharpe Ratio of the JSE All Share Index relative to these fixed income instruments since 2000.

 

Source: Morningstar (end Nov-21)

 

The fixed-income environment gives an investor a useful indicator of the direction of future economic activity, i.e. bond prices and bond yields are excellent indicators of the economy as a whole, and of Inflation in particular. The graph below illustrates changes in bond yields with the direction of interest rates over the past 20 years.

 

Source: Bloomberg (end Nov-21)

 

The steepness of the yield curve implies strong economic growth, while the inverted yield curve suggests an economic slowdown or warns that a recession is coming.

 

Source: Absa Asset Management (end June-21)

 

The above graph illustrates the credit rating of South Africa’s (SA) bonds through the various rating agencies. As SA’s credit rating improved, so did its holdings by foreign investors. Even when SA exited the World Government Bond Index (WGBI) in April 2020, foreigners continued to hold SA bonds at levels before its exit. This clearly illustrates the quality of SA bonds, i.e. that while the credit rating on SA bonds has deteriorated, the yield on them has remained attractive to foreign investors.    

Over the past 18 months (i.e. over the COVID-19 pandemic period), many managers have realised that bonds are anything but boring, but rather an important diversifier in their portfolios that will dampen volatility.

As the name states, fixed-income instruments aim to provide regular returns (which may be more modest) but are generally secured. These instruments serve a critical role in many portfolio strategies, such as:

·       reducing overall volatility;

·       providing liquidity; and

·       diversifying risks.

They are able to provide stability but have lower long-term returns than equity. Fixed-income instruments such as bonds are able to provide a predictable stream of income, that equities can’t. And in some cases these instruments may be government guaranteed providing safer return for investors and also may have a higher claim to assets in bankruptcies.

The ”boring” approach to fixed-income investing is the most efficient way to achieve “long-term” success, because it reduces investors’ likelihood of making mistakes when their normal emotional response would be to do something they shouldn’t (also known as acting irrationally).

The “boring” approach to investing means more peace of mind and less stress. Isn’t this what you wanted to start with?