Bonds vs. equities: What value do they add to an investment portfolio?

A measured exposure to bonds will help to keep an investor resolute. The more bonds one has in an investment portfolio, the less one stresses about temporary equity market declines, mitigating the common mistake of selling out of equities at a loss. But what value does bonds and equities add to an investment portfolio?

While equities are exciting, bonds are boring.

Over time equities provide the best returns, compared with bonds. Although in the short-term bonds tend to be safer, in the long run they provide lower returns, said Overberg Asset Management (OAM) in its weekly economic and market overview.

"Bonds are an effective portfolio diversifier. Diversification into bonds, which traditionally have a negative correlation to equities, will temper the volatility of the equity portion of an investment portfolio."

According to the analysts at OAM, a measured exposure to bonds will help ensure that investors stay the course, maintaining equity exposure through thick and thin.

South African economic review

• The Absa/ BER manufacturing purchasing managers’ index (PMI) jumped in July from 47.9 to 51.5 regaining the expansionary 50-level after averaging 49.5 in the second quarter.

Of the sub-indices showing improvement, the business activity index increased from 45.8 to 50.3, the employment index from 46.0 to 50.8, suppliers’ performance from 51.5 to 54.0 and the forward-looking new sales orders index from 49.1 to 52.8. Marring an otherwise upbeat survey, the prices sub-index increased sharply from 73.6 to 83.6 reflecting the inflationary impact of the weaker rand and rising oil price.

Of greatest concern, the expected business conditions index, a measure of expected conditions in six months’ time, fell from 55.7 to 48.7 its first sub-50 reading since August 2017, likely reflecting increased global uncertainty over trade protectionism.

• Total new vehicle sales increased in July by 2.6% year-on-year down from 3.0% growth in June. While commercial vehicle sales retreated by 0.7% passenger vehicle sales increased 4.3% amid buoyant consumer confidence and lower interest rates.
Among the commercial vehicle sales categories, light vehicles contracted 2.3% while medium and heavy vehicles grew by an encouragingly robust 15.9% and 27.9%, respectively. Despite the weaker rand, new vehicle exports fell sharply by 19.2% on the year due to the base effect of a high comparative level in 2017. Growing trade protectionism is likely to keep export sales under pressure.

• The trade balance registered a substantial R12bn surplus in June well above May’s trade surplus of R3.8bn, with exports rising 7.1% month-on-month while imports declined 0.9% on the month. Following four straight months of surplus the cumulative trade deficit for the year-to-date has reduced to R1.8bn, which although below last year’s R25bn surplus over the equivalent period, bodes well for a reduction in the country’s current account deficit. A reduction in the current account deficit would be rand positive.

• The Labour Force Survey unemployment rate jumped to 27.2% in the second quarter (Q2) from 26.7% in Q1. Over the quarter, employment fell by 90 000 while the number of unemployed increased by 102 000. Both formal and informal sectors lost jobs, by 35 000 and 73 000 respectively. By sector, the worst job losses were recorded in manufacturing at 105 000, the community and social services sector (mainly government services) at 93 000 and trade at 57 000. Job gains were recorded in transport at 54 000, and surprisingly in construction at 45 000 and mining at 38 000. On a year-on-year basis, the overall trend remains mildly positive with a total 188 000 jobs created. However, the number of discouraged job seekers surged by 503 000 on the year. Jobs growth depends on improved business confidence levels, which in turn relies on the implementation of pro-growth policy reforms.

The week ahead

• Manufacturing production: According to consensus forecast manufacturing production is expected to have shown nil year-on-year growth in June, following growth of 2.3% in May. Expectations of a disappointment stem from lacklustre survey data. The manufacturing purchasing managers’ index (PMI) averaged 49.5 in the second quarter (Q3), which below the neutral 50-level signifies modest contraction. However, with the PMI regaining the 50-level in July, some respite in manufacturing production is expected in Q3.

• SACCI Business Confidence Index: Since spiking in January to 99.7 its highest level in 27 months, boosted by “Ramaphoria”, the SACCI Business Confidence Index has dropped for 5 consecutive months ending in June at 93.7. The Business Confidence Index for July will be closely watched for indications of a potential recovery in investment spending.

Technical analysis

• Although the rand has broken its spell of recent declines and now consolidating in a trading range of R13.00/$ to R13.50/$ the likelihood of continued strength below R13.00/$ is limited. The trading range is likely to persist for the foreseeable future.

• The rally in the US dollar index has reached its medium-term goal suggesting a correction from current levels. The dollar remains below a major 30-year resistance line suggesting the bull run in the dollar may be over.

• The British pound has broken back below key resistance at £1.35/$ suggesting a trading range of £1.30/$ to £1.35/$. The £1.28/$ level is expected to provide strong resistance.

• The JPMorgan global bond index is testing the support line from the bull market stemming back to 1989, which if broken will project further sharp increases in bond yields.

• The US 10-year Treasury yield is struggling to break decisively above key resistance at 3.0%. However, a break above this level is expected and would open the next target of 3.6%.

• The benchmark R186 2025 SA Gilt yield has retraced earlier weakness and fallen back below the key 9.0% level. A trading range of 8.4-9.0% is expected over the foreseeable future.

• Key US equity indices, including the S&P 500, Dow Jones Industrial, Dow Jones Transport, Nasdaq and Russell 2000, have simultaneously set new record highs, confirming a bullish outlook for US equity markets.

• The Brent oil price has struggled to break above key resistance at $75 per barrel, indicating a likely trading range of $65 to $75 per barrel.

The outlook for base metals prices is less certain after the copper price retreated sharply from the key $7 000 per ton level. A break below $6 000 per ton would herald a bear market in copper and base metals’ prices.

• Gold has developed an inverse "head and shoulders" pattern, which indicates a price recovery and a test of the $1 400 target level.

• Despite the consolidation since the start of the year the break in the JSE All Share index above key resistance levels at 56 000 and 60 000 in December signals the early stages of a new bull market.

Bottom line

• Bonds, which are debt instruments issued by sovereign entities and companies to raise capital, play an important role in investment portfolios. Bonds pay the investor interest over the life of the bonds. The interest can be at a fixed rate or a floating rate linked to the prime rate or to the inflation rate. Zero coupon bonds pay no interest but provide a fixed capital return.

• While equities are exciting, bonds are boring. Over time equities provide the best returns, by far, compared with bonds. Although in the short term bonds tend to be safer, in the long run they provide lower returns. In South Africa, based on historical experience, equities are likely to provide an annualised real (adjusted for inflation) return of 7-9%. Bonds, on the other hand, will likely provide 1-3%, lower than equities but higher than cash at 0-2%.

• If the expected long-term annual return on bonds is so much lower than equities, what value do they add to an investment portfolio? Bonds have a dual purpose. They are especially useful for investors who require a secure income stream. The income generated by bonds tends to exceed the income yield on cash.

• Bonds are an effective portfolio diversifier. Diversification into bonds, which traditionally have a negative correlation to equities, will temper the volatility of the equity portion of an investment portfolio. While equities have historically been by far the best performing asset class, they are notoriously volatile. In the worst 12-month declines for the All Share Index over the past twenty years following market peaks in April 1998, May 2002 and June 2008, the All Share Index suffered losses of -39%, -30% and -38.5%. These losses would be enough to unnerve even the most seasoned investors. However, in each case resolute investors would have been rewarded, outperforming the inflation rate on an annualised basis in less than four years after the initial decline.

• A measured exposure to bonds will help to keep an investor resolute. The more bonds one has in an investment portfolio the less one stresses about temporary equity market declines, mitigating the common mistake of selling out of equities at a loss. Unfortunately, buying high when everyone else is buying and selling low when everyone else is selling is human instinct and comes quite naturally. Bonds offer the ballast, which protects against succumbing to human instinct.

• Asset managers seldom agree, but they are agreed on one thing: Investors must invest over the long term. A measured exposure to bonds will help ensure that investors stay the course, maintaining equity exposure through thick and thin. The degree of exposure to bonds depends on an investor’s financial needs and risk profile.

For the full report, including a look at international markets, click here.

* Overberg Asset Management (OAM) is an Authorised Financial Services Provider No. 783. Overberg specialises in the private management of local and global discretionary portfolios as well as pension products.

Disclaimer: Information and opinions presented in this report were obtained or derived from public sources that Overberg Asset Management believes are reliable, but makes no representations as to their accuracy or completeness. Any opinions, forecasts or estimates herein constitute a judgement as at the date of this Report and should not be relied upon. There can be no assurance that future results or events will be consistent with any such opinions, forecasts or estimates. Furthermore, Overberg Asset Management accepts no responsibility or liability for any loss arising from the use of or reliance placed upon the material presented in this report.