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Inflation is your money’s number one enemy. It is also the nemesis of most central banks as they try to keep it within various bands and as low as possible. In South Africa, our CPI should remain within a 3 – 6% band and this is the job of the SARB. Currently it is nosing slightly higher than that, but despite headwinds like our hugely volatile but mostly depreciating Rand, they seem to have it under control.
Uncertainty or surprises are the things that frighten investors most and so unexpected spikes in inflation cause havoc. One way around this is to invest in inflation linked bonds (ILBs) which compensate you for inflation no matter what it does.
Daphne Botha, portfolio manager at Futuregrowth Asset Management does a great job of explaining how they have managed to give investors superior fixed interest returns using ILBs and other forms of credit. – Candice Paine
This interview is brought to you by Futuregrowth Asset Management and I’m speaking to Daphne Botha, who is a bond portfolio manager at the group. Today we’re talking specifically around inflation linked bonds and how they fit into your portfolio. Daphne, tell us about ILBs.
Inflation linked bonds in South Africa is a relatively young asset class. We consider them as a separate asset class while many local investors still consider them as part of their bond allocation, which we think is wrong. It should definitely be considered as a separate asset class.
Because they behave differently to nominal bonds?
Yes, definitely. At times you can find that the nominal bonds versus inflation linked bonds will react differently, depending on how inflation comes out.
Okay and what would make that difference? Inflation linked bonds – generally the coupon and the underlying payment is keeping up with inflation. Whereas nominal bonds are not necessarily so.
Yes.
So how do they react differently?
For instance, if you look at a nominal bond, for instance say the coupon is 10%. If you assume long term inflation is 6%, you’ve got a 4% implied real yield. If inflation comes out higher than that over the period of the life of the bond you’ve actually lost some value, due to inflation and vice versa, whereas with inflation linked bonds it actually goes the other way around.
You’ve got a real rate, which is set much lower, so currently in our market it’s between 1.8% and 2%, and then you earn that real yield plus whatever inflation comes out at. Here you don’t need to worry about future inflation.
You’re actually getting the benefits, especially if it’s higher, that’s where you would benefit. You would get that automatically, in the value of the coupon as well as the value of the capital at the end that you get repaid.
Read also: A Macro Outlook for bonds from Futuregrowth Asset Management
So you need to hold it to maturity, essentially or are there times when you can sell?
Yes, you don’t need to hold it to maturity. It’s built into the pricing of the instrument, so you can trade in and out of it, at times, depending on your view on inflation. Obviously, if inflation rises you want to go and buy as much as you can but when it peaks and it starts dropping, that’s when you actually want to get out of the asset class.
Where are we in the cycle at the moment because there seems to be a lot of pressure on inflation currently?
Yes, look South Africa is in a very peculiar place where inflation tends to remain quite high. We have a 3% to 6% inflation target range but in general, I mean for the last year or two, we’ve been between 5% and 6%. In fact, in the last couple of months we’ve actually exceeded the 6% target range and one of the reasons why the Reserve Bank started hiking over the last two years, was to manage that so that it doesn’t get out of control. Where are we in that cycle? We think we’re getting towards the top end of the range.
We can get one or two more spikes higher obviously it depends on where oil comes out at, or where food price inflation lands up. Also, where the currency ends up, but the forecast is into next year, so we always need to look forward. The forecast is for inflation to come down, so we have to factor that in.
What does that mean for your actual trade? When do you know when you’re going to be buying inflation linked bonds and when you’re going to be buying nominal bonds?
From an inflation perspective your inflation carrier, as we call it in our market, is probably going to reduce as inflation comes down but we’re not talking about low-low inflation. Inflation is probably still going to be in the 5% range, which is still relatively high compared to what you’re seeing in the rest of the world. There’s still a place for inflation linked bonds, especially if you have liabilities, as Pension Fund that’s matched to that.
Read also: Brian Kantor knocking on SARB’s door – worry about economy, not inflation
Okay, so that pretty much sorts out the liability side of it.
Yes.
Let’s talk a little bit around the Futuregrowth Yield Enhanced Inflation Linked Bond Fund, you form part of the team that manages it?
Yes.
How do you use these in the fund and what is your positioning currently?
This portfolio is actually benchmarked to a single month. Our oldest fund in that suite is benchmarked to the R202, which is the 2033 maturity inflation linked bond, issued by the South African Government. We have to match the interest rate risk of that particular bond, so we take possession. If we think inflation is going to rise then we’ll buy into it, and vice versa, but it’s also not just that.
It also depends on where the absolute levels of real yields are relative to where nominal bonds are. If we think real yields are low, maybe you don’t want it as much. If you think real yields are at a decent level or high enough then you want to enter that, so there are various factors that will effect that.
So despite what the name implies, inflation linked bond funds, you can actually use other credit instruments in there to reach your goal.
In this particular product we have yield enhancement, as an extra value add or an extra alpha source in the portfolio, because the listed inflation link credit market is very limited, the yield enhancement is very low, or the SOEs you’re talking about 50 to 70 basis points of excess yield.
We access the nominal credit market, especially in our unlisted nominal credits, we’re talking about yields in excess of 300 basis points. So we use a combination of these credits obviously, but by accessing that market, we’re able to secure higher yields, and higher excess returns with that.
Does that bring in higher risk? You know, everybody is still suffering from the hangover of the Abil disaster last year, although they may not have understood the credit risk there, many people were exposed to it. In this unlisted space – what are the increased risks we’re looking at?
Well personally, in our view anyway, our unlisted credits have more protection than listed credits, so when you enter credit…
Why is that?
Because we’ve built in more governance, more protections, we have more opportunity to negotiate the legal’s to our satisfaction, as lenders. Just think about when you go and get a bond or a loan at the bank. The bank wants everything as security. We’re the bank in this case, so we want to take everything that we can to ensure that we get at least our capital back.
Read also: More pain? Inflation surprising SARB, could peak at 8.1% in December – Montalto
So you’re comfortable that the due diligence is being done by you and that the credit is worthy?
Yes, sure definitely and also, as I said, we have more chance to affect those legal’s in the unlisted space. In the listed space it’s a very much ‘take it or leave it’ situation. In most cases we actually leave it, when we feel uncomfortable with the risks that we’re taking on. Credit is about risk and reward, like most investments.
If you’re uncomfortable with the additional risks that you’re taking or you feel that it’s not compensating you for those risks, then you step away, it’s quite simple.
What has that extra layer of care meant for the absolute return of the Futuregrowth Yield Enhanced Inflation Linked Bond Fund?
So over the past three years, in that particular fund we’ve had returns in excess of 2.5%. It’s been fairly consistent and stable. That you will not be able to get in the listed market, especially not in a vanilla yield enhanced inflation linked product.
That’s the real yield you’re talking about?
No, so that’s an additional, in terms of the real deal, so if you look at the return sources of that fund, you’ll get inflation because your return is affected by what inflation offers. Then you get the real yield, which is between 1.8% and 2%, and in addition to that you get this extra close to 3% yield.
Okay, so it’s done really well, through this strategy?
Yes, definitely.
If you had to attribute that performance does a lot of it come from the unlisted space or is it a combination, depending on what’s going on?
It is a combination, so the bulk of it is the unlisted yield enhancement. There’ll be some listed yield enhancement. There’ll also be some return coming from your interest rate positioning, relative to the benchmark.
What type of an investor would be going into a fund like this?
This is more a product for institutional investors, so ideally your Pension Funds. Your Pension Funds have pensioners that they have to pay inflation linked liabilities out too, over a long period of time. Against that, to have an inflation of assets that matches that and gives you a little bit more – provides the more positive asset liability match that they require.
Daphne Botha thanks so much for speaking to me today. Daphne is a portfolio manager at Futuregrowth Asset Management.
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