David Knee, Co-Deputy Chief Investment Officer, Fixed Income M&G (UK)

 

Global fixed income assets are now able to play a more significant role in South African investors’ portfolios as fixed-interest bond yields are high around the world.

 

South African investors have necessarily limited their exposure to global fixed-interest bonds over the past several years for two primary reasons: unattractively low yields and the 25% offshore asset restriction for retirement portfolios under Regulation 28.

 

Under the 25% limit, it made sense to allocate the global allowance primarily to global equities and cash, given the upside to potential returns of the former and high risk-reduction and liquidity benefits of the latter.

 

However, the February 2022 increase in the offshore limit to 45% effectively opened up a new world of opportunities to South African investors, and global fixed-interest sovereign bonds, in particular, can offer considerable benefits to a local portfolio generally and currently present an excellent buying opportunity.

 

Why global fixed income?

 

South African investors have several good reasons to consider adding global bonds to their portfolios, the most important being their effectiveness in lowering the risk of local balanced portfolios.

 

For example, a standard balanced portfolio with 60% SA equity and 40% SA bonds will experience a significant reduction in risk (as measured by its standard deviation) as increasing amounts of global bonds are added: with no global bond exposure, the portfolio’s risk is around 12.5% p.a., which falls meaningfully to around 10% once an 18% weighting of bonds is reached. This is due to both the diversification of geography, currencies and economies, and the inherent lower volatility of bonds as their weight expands in the total portfolio.

 

Another key reason to buy global bonds is their currently high yields on an absolute basis compared to history. Today’s global bond yields reflect the steep hikes in base lending rates implemented by global central banks between 2021 and mid-2023, and subsequently kept steady.

 

Although yields have fallen from their highs, they are still at attractive levels. For example, the 10-year US Treasury yield has been trading around its 20-year average of 4.5%, after having stayed below this level since 2008. At the same time, expectations are for central banks to keep interest rates higher for longer in the face of persistent (but lower) services inflation in many countries.

 

In fact, 10-year interest rate forecasts as priced into the US forward rate agreement (FRA) market are much higher than those of the US Federal Reserve (Fed).

 

This could be due to concerns over the increasing US fiscal deficit and the need for higher funding in the bond market, although the US has fewer reasons to worry than other countries due to the US dollar being the global reserve currency. In the UK, however, the government needs to raise almost £1trn in debt over the next five years, which is equivalent to almost 40% of its outstanding debt stock. These pressures could also contribute to keeping global interest rates higher for longer should nervous buyers demand more compensation for owning sovereign debt.

 

In our view, the current environment is not an ideal environment in which to start cutting interest rates, especially given the elevated prices of global risk assets. Not only are stock markets hitting all-time highs, but in the corporate credit market, keen investor demand for both investment-grade and high-yield bonds, driven by higher interest rates, has pushed spreads versus government bonds to unattractively low levels.

 

ENDS