ANTON ESER: Are bonds high yield or high risk?

Earlier this month, SA 30-year bond yields spiked briefly above 13%. While they have now come back slightly, these are still levels not seen in 20 years. Local inflation-linked bonds are also offering multidecade high real yields of more than 5%.  

Yields in many other markets are looking similarly attractive. At about 4.3%, 10-year US treasuries are trading at levels last seen before the global financial crisis. 

While these yields make this a great time to own fixed income, investors should remain cognisant of three material risks. The first concerns SA’s fiscal sustainability. SA government debt has been on an upward trajectory since 2008 and our debt-to-GDP ratio is now about 75%.  

The problem the country faces is the high interest rates we have to pay on that debt. Roughly 20% of tax revenue is now spent on interest payments. According to Bloomberg, the median for other emerging markets is 8%. 

Climbing debt

The second risk is the level of global debt. Many states have  increased their debt levels significantly in recent years, with the US being the most prominent example. 

A lot of this is due to the Covid pandemic. After World War 2 the Marshall Plan amounted to 5% of US GDP. The array of fiscal spending during Covid was equal to 19% of GDP. That has sent the US debt-to-GDP ratio to 120%. 

This was not such a significant issue when central banks were keeping interest rates artificially low. However, by raising rates to combat inflation central banks have also made paying for this debt a real concern. We may be reaching a point where bond markets start to get nervous about how this debt will be funded. 

Credit cycle

The third risk is where we find ourselves in the global credit cycle. Over the past 30 years we’ve have had three credit cycles. The first ended with the recession in 2001, and the second with the global financial crisis. We may now be getting towards the end of this one. 

This is because as interest rates go up more marginal companies will struggle to make payments on their debt. That reflects in defaults picking up, which we are seeing in the US. Given these risks it is important for investors to think about how multi-asset income funds in SA are positioned.  

The right quality

According to Morningstar data, the average income fund in the local market has about 30%-40% invested in credit. Does this make sense when default risk is rising, particularly when you can build a relatively high-quality portfolio without any credit and still generate yields well above inflation? 

Most notably, investors can earn close to 13% from government bonds. But, even there you need to be aware of the inherent risks, particularly what would happen if inflation got out of control. 

This is where inflation-linked bonds are an underappreciated asset class in SA. There is good reason to use them alongside nominal bonds to express a constructive view on duration.  

Consider that if we see an increase in government spending, structural reforms don’t come through and SA stays in a low growth or even negative growth environment, we will see a sharp acceleration in government debt. That will spook bond markets, but is unlikely to lead to a default. 

If you look at a number of emerging markets where there has been a shift towards populism, what happens is that you get loose monetary and fiscal policy. That leads to high inflation and a depreciation in the currency. Turkey is a good example. 

Under the unconventional policies of President Recep Tayyip Erdogan Turkey’s rate of inflation increased to more than 85% in late 2022 and is now more than 75%. 

So, what do you own in an environment like that? What the Turkey scenario showed is that the way to hedge against that kind of tail risk is through inflation-linked bonds. 

Between January 2020 and March 2024, when inflation in Turkey averaged 52.4%, inflation-linked bonds gave investors an annualised return of 48.5%, according to Bloomberg data. In other words, they almost fully maintained investors’ wealth. 

Nominal bonds, in contrast, gave an annualised return of just 0.5%, meaning investors lost 50% of the value of their money each year on average. 

Investors have shied away from inflation-linked bonds in SA because they have underperformed over the past few years. But these bonds provide that hedge against a high-inflation scenario that shouldn’t be ignored. 

• Eser is chief investment officer at 10X Investments.