SA government bonds endured a tough second quarter, delivering a negative return of 1.5%. Longer maturity issues were especially weak and sold off heavily alongside the rand, as adverse investor sentiment contributed to increased volatility in the domestic bond market.
In the absence of adjusting volatility for forward-looking estimates around expected asset returns, volatility is a relatively blunt risk management measure on a standalone basis.The graph below shows the volatility of rolling 12-month total returns of the FTSE/JSE All Bond Index as a proxy for the domestic bond market. It also shows the net monthly purchases of South African government bonds by non-resident or foreign investors over the last 10 years.
In secondary markets, bid-offer spreads provide an indication of the price and yield where buyers and sellers are willing to trade. High spreads indicate buyers and sellers are relatively far apart in terms of what they consider a fair price to trade. Foreign currency bonds are higher risk, but government has managed that exposure conservatively, with South Africa having relatively low levels of hard currency debt compared to emerging market peers. The country is, however, somewhat of an outlier across the EM complex in terms of exposure to contingent liabilities from failing state-owned enterprises and parastatals.
Higher duration does not necessarily mean higher risk. The starting yield and investment horizon are exceedingly important. The key question for investors is whether bond yields provide a sufficiently high margin of safety to compensate for potentially higher interest rates and inflation over their investment horizon.
Yield has historically been the biggest driver of total returns and is usually a good indication of the return investors can expect to earn by holding the bond to maturity. The above graph shows that besides the Covid-19-induced selloff in 2020, current bond valuations are at their most attractive levels since 2014.