Background: Investors are facing unprecedented volatility within fixed rate and inflation- linked bonds (“ILB”) lately. Since the U.S. Federal Reserve (“Fed”) Chairman provided guidance that they may ‘taper’ the pace of US Bond purchases in May 2013, bond markets across the world experienced price depreciation as US 10 year Treasury yields spiked up from 1.65% to the current 2.75%. Emerging Market Bonds, US TIPS (ILBs) and fixed rate corporate & high yield bonds all followed the same pattern, as did most high yield asset classes like listed property and high dividend yield stocks. These asset classes are the cornerstone of low risk portfolios, which experienced unprecedented price volatility and – in some cases – temporary capital loss as a consequence.
On 18 September the Fed Chairman reversed his views and commented that there has been ‘growing underlying strength in the economy’, but wants to ’wait that more progress has been made before adjusting the pace of its bond purchases’. While the Fed’s decision is unsurprisingly bond, equity and emerging market currency positive, investors question us on why we are holding bonds in our portfolios, knowing that the US will need to taper its bond purchases sometime in the future with negative consequences to fixed rate bonds.
Why did Inflation-Linked Bonds experience volatility lately?
SA Inflation-linked bonds (ILB) as an asset class have been around for more than 13 years in our market. Over this period returns averaged around 13% p.a, during which we had cycles of sharply rising and falling inflation and interest rates.
Although one would think that the price of an ILB should be driven by the underlying inflation trend, one needs to accept that there will always be leads and lags during a cycle, as real yields adjust due to monetary policy actions or expectations. Changes in the real yield of an ILB cause capital volatility and dominate the capital value of returns when the real yield contracts or expands. During the past 2 years ILBs experienced a perfect storm in S.A., with rising inflation, low interest rates and plummeting real yields. The Fed’s tapering comments ended the tea party as fixed rate bond yields spiked up without any US inflation fears in the system and taking the Barclays US Inflation Linked Bond 7-10 year Index from -1% to + 0.6% (currently back to +0.3% real yield). SA Real Yields responded to the trend, the CILI Index’s 10 year real yield correcting from +0.75% to +1.79%.
Will this volatility continue?
A further rise in US and SA real yields should be fairly contained (if at all), as the US economy does not appear to be in need of significant policy tightening – the Fed actually requires higher US inflation! SA Monetary Policy seems to be content with the rising domestic inflationary threat by not raising interest rates. This should keep local real rates stable, resulting in inflation dominating the contribution to performance instead of capital volatility.
Conclusion
Any CPI benchmarked portfolio should hold ILBs as the Inflation element + the Real Yield will ensure that the CPI liability is matched over time. Our mean variance optimization research confirmed the following characteristics of ILBs.
It should be a buy & hold strategy for long term investors and
- Other than cash (at a current negative real yield of 1%!) –it is the most non-correlated of all conventional asset classes. Since its launch on 21 may 2009, the RMB GOVI ILB has returned 9.15% vs. CPI + 2% of 7.18% and Cash at 6.18% p.a.
- We expect this trend to continue in the next 2-3 years.
