'Choose money market, not bonds'

Cape Town - According to Andrew Lapping, a portfolio manager with Allan Gray investment managers, the risk of capital loss in the bond market exceeds the potential for capital gains, and accordingly the company prefers the lower risk of money market assets to bonds.

"South African bonds are currently discounting a long-term inflation expectation of 5.5% to 6%," Lapping said in the company's monthly circular distributed on Monday. "At Allan Gray we believe that inflation is likely to exceed 6% in the long term. When the risks of inflation being either much higher or lower than 6% are considered, we think we think there is greater risk of inflation rising.

"A further consideration is that the borrowing requirement of the South African government is increasing. This may cause investors to demand higher real yields as the supply of bonds increases, placing downward pressure on prices."

Lapping noted that over the past 10 years South African bond investors have required a real return of about 3% on average. The yield difference between nominal bonds and the inflation-linked bonds can be used to illustrate inflation expectations. A nominal bond pays a fixed coupon, while an inflation-linked bond pays a coupon linked to the inflation rate.

The quoted yield on an inflation linker is the real return the bond will give above inflation over the life of the bond. The real return on inflation- linked bonds has recently declined from 3.4% to 2.1%.

Bond funds will yield good total returns when bond prices move from discounting a high inflation rate to a lower one. In this instance bond prices will rally as yields decline.

- I-Net Bridge