Emerging market bonds still the investment of choice
The risk-seeking behaviour of developed market investors whereby they invest in emerging market bond markets continues unabated. For the past five years, central banks in developed markets have successfully encouraged investors to buy assets at inflated prices. These policies continue as the US Federal Reserve (the Fed) remains dovish on its interest rate policy stance, irrespective of the fact that consumer inflation is close to the Fed’s target rate. In Europe, the European Central Bank cut interest rates down to zero and added further stimulus to the European banking system. The question is: why do investors keep on buying emerging market debt even though emerging market fundamentals, like South Africa’s fundamentals, are a lot less attractive than those of developed markets?
The hunt for yield
Let’s place ourselves in the shoes of these developed market investors for a moment. A central bank lends you cash at near to zero percent, inflation is low and your currency is stable. How do you make a real return for your investors? Interest rates in developed markets are at generational lows and asset prices seem stretched. Then, emerging markets come onto your radar. Depending on the fundamentals of the specific country, these markets offer yields of between 3% and 12%. South Africa specifically stands out in our emerging market time zone due to the high nominal yields and the liquidity of the markets on which to trade these yields, as shown in Chart 1.
It seems investors have forgotten bond fundamentals in this hunt for yield
Governments globally are spending and borrowing more to stimulate growth in their respective economies. Currently, budget deficits in most economies are either stable at best or rising, as shown in Chart 2. If governments are borrowing more than ever, why are investors willing to accept to buy this debt at low yields and high prices? In addition, governments are extending the maturity profile of their debt, and yet investors are still willing to accept this longer-dated debt at high prices. The bulk of government issuance in South Africa is for maturity dates between 2020 and 2048. Another problem is that the government uses these long-term borrowings for current expenditure, not infrastructure development. The duration risk (interest rate sensitivity) of investors’ portfolios is rising. Demand and supply dynamics in bond markets seem totally out of balance. For us, this scenario represents a margin of safety risk. We feel that we do not have to buy government debt with long duration risk if the current trend is for government to issue a substantial amount of paper into the market over the foreseeable future.
With central banks encouraging this risk-seeking behaviour, investors seem to have forgotten the true fundamentals of bonds. The fact that more bonds than ever are being issued into markets, as mentioned above, does not seem to matter. It also does not seem to matter at what level the bonds trade as long as it is at some level above cash returns. Bond investors are comfortable to buy bonds as long as they know central banks will just keep the printing press going. Is this irrational behaviour reason enough to expose investors’ money to this type of long duration risk?
Do real yields matter?
Very few market commentators are talking about the real returns earned on bonds, since inflation in developed markets is low, as shown in Chart 3. It seems like the focus is on comparing bonds with cash, with no real regard for risk-adjusted returns in fixed income markets. Valuations mean little when the printing presses roll on. Over time, long- dated bonds have to yield a fair margin above inflation to compensate the investor for the term risk inherent to these bonds. Long-dated bonds in South Africa currently yield a positive return above inflation but it is low, at about 1.6%. The long run (or what we call through-the-cycle) 10-year nominal yield above inflation is between 2% and 2.5%. This is why we feel the margin of safety in nominal bonds is currently too low. Only when this margin returns to more normalised levels would we invest in longer-dated bonds.
Cautious when others are greedy
In the current environment, where risk-seeking behaviour from foreign bond investors is keeping long bond yields at low levels, we choose not to be greedy. Eventually, there will be a return to bond fundamentals, and this will be reflected in higher yields. The return to more normalised real returns on bonds will be a buy signal for us. Initially, real returns in fixed income markets may not be reflected in official rates, but markets will start pricing for the event. Investors will start demanding higher real returns on bonds as the growth dynamic gathers more momentum.