In a world of declining bond yields, many investors, both private and institutional, are concerned that the yield does not justify the investment.
The yield on the benchmark 10-year bond, the R157, is at 7.85 percent, very low by historical standards. The yield averaged just over 9.5 percent in both 2004 and 2003.
With the government publicly expressing its desire to achieve a 6 percent economic growth rate, and circumstances indicating that it may very well be able to achieve this, bond yields do not seem that attractive.
Why would you want to invest in bonds if the equity market is promising returns of 10 percent (using real economic growth of 6 percent and expected inflation of 4.5 percent to give a simplistic estimate)?
Well, for a start, the risk in debt investment is considerably lower than in equities. In the bond market, you know what your future cash flows will be and you should therefore expect returns in excess of this when you invest in equities.
Also, one needs to evaluate the risk of capital loses if one were to sell the bond investment in the future. The main question here is what the probability is of either the repo rate being increased or of inflation rocketing higher. In our view, neither of these is likely in the next year and a half. So in terms of the risk-reward relationship, bond yields are not a bad, if not an exciting investment. In fact, the bond market is set to be a downright boring place over the next year or so.
Yields seem set to track sideways or marginally lower, providing some scope for capital gains but not much. Unless, of course, the monetary policy committee (MPC) throws us another rate cut. While we do not forecast this, Barclays does believe there is a risk for such a cut next year.
The bond market, however, does not end with normal bonds. There is another asset class called inflation-linked bonds. I call this another asset class as while it does resemble a bond, its risk-reward relationship is entirely different.
An inflation-linked bond pays a series of interest payments and a set capital value at the end. However, all of these cash flows are inflated by the headline inflation rate.
This instrument is therefore the perfect hedge against inflation as long as it is held to maturity. No other asset class offers such a perfect hedge.
The bond trades in yield, but it is called a real yield as the actual return over the life will be the real yield plus inflation. Normal bonds incorporate expected inflation into their yield, as well as a risk premium to compensate for this risk.
The real yield is by nature much less volatile, and so are the returns of this asset class. Consequently, it is seen as one of the lowest-risk investments.
The eight-year real yield is about 3.2 percent, while the equivalent bond yield is at 7.8 percent. Subtracting the one from the other tells us that if inflation is higher than 4.6 percent over the next eight years, you will do better having invested in the linked bond.
Given that the middle of the MPC's target range for inflation is 4.5 percent, there is very little extra reward for investing in the normal bonds at present, compared with the linked bonds. The risk premium is close to zero.
So while we believe normal bond yields may drop over the next few months, inflation-linked bonds are an attractive investment.
- Leon Myburgh is an interest rate strategist at Barclays Capital