It’s considered common knowledge that including fixed income instruments in your portfolio adds stability and a can generate a regular income.
Fixed income investments primarily involve debt instruments—most commonly bonds—issued by governments, municipalities, or corporations. Investors lend money to these entities in exchange for regular interest payments over a specified period, culminating in the return of the principal amount at maturity. The predictability of these cash flows is what categorises these securities as “fixed income.”
Fixed income hedge funds take this concept even further by employing sophisticated strategies to optimise returns while managing risks. These funds may take long and short positions in fixed income securities, use derivatives like futures and options, engage in repurchase agreements (repos), and even delve into currency and commodity markets to enhance portfolio performance.
The advantages of investing in fixed income include the following:
We know that fixed income can be a bit “uncool” or boring (for others, not us at Cartesian Capital) – and what is that nonsense about buying high and selling low to make a profit?!
So, let’s explain to you why we like fixed income in the current South African context.
Why fixed income as a preferred sector in the current environment
One of the key features of fixed income is the inverse relationship between interest rates and bond prices. When interest rates fall, the price of existing bonds rises. This happens because newly issued bonds get offered at the now lower yields than in the higher interest rate environment, making older bonds with higher coupon rates more attractive.
Investors holding bonds during this period can capture capital gains by selling them at higher prices in the secondary market. Long-term government bonds in particular are sensitive to interest rate movements – a small dip in rates can significantly increase their value, offering investors attractive capital appreciation opportunities.
Although future yields may decrease as rates continue to fall, fixed income instruments bought before the decline will continue to pay higher coupon payments. This creates a yield advantage for investors who have locked in their positions early; whether on floating rate or fixed rate instruments. For floating rate notes, the lag in the coupon reset allows fixed income funds to continue outperforming their benchmarks as their benchmarks experience a more immediate impact of falling rates. In a low-rate environment, these higher yields provide steady income, which becomes more valuable as other savings vehicles offer diminishing returns.
Price is what you pay, value is what you get
And the value of diversification cannot be underestimated.
Fixed income assets play a crucial role in diversifying portfolios and mitigating fund risk and volatility. As interest rates fall, stock markets may experience volatility—either due to changes in investor expectations or economic uncertainty. In such times, the relatively predictable nature of fixed income securities provides some stability. Government bonds in particular are considered lower risk compared to equities. They act as a hedge, balancing out portfolio performance during market turbulence and protects overall value.
It is worth noting here that when you buy a fixed income instrument, you know what yield to maturity you are going to receive. The major risks to your portfolio are Default by the Issuer and daily Mark-to-Market which impacts on the current value of your portfolio.
Lower interest rates also benefit the corporate credit landscape by reducing borrowing costs for companies, improving their ability to service their debt and expand business operations. This often leads to tighter credit spreads, improving bond prices. Companies may refinance existing debt at lower costs, leading to reduced default risks and higher credit ratings. For investors, this translates to reduced risk in holding corporate bonds and the potential for credit spread compression, which can further improve bond prices. High-quality corporate bonds, therefore, become more attractive investments in this environment, as they offer both steady income and reduced credit risks.
The South African perspective
The positive sentiment surrounding the Government of National Unity (GNU) was first reflected in the fixed income market, thanks to the stability and confidence it conveyed. The establishment of the GNU reassured bond investors of the government’s commitment to effectively managing fiscal policies, fostering a sense of security in the market. The SA CDS (Credit Default Swap) is currently trading as low as 265bps, reflecting international investors’ confidence in the ability of the South African government to repay outstanding debt.
Bond prices tend to be more sensitive to shifts in sentiment regarding economic stability than equities. Currently, the yield on South Africa’s All Bond Index remains near the crisis levels experienced during the “Nenegate” period, when Des van Rooyen briefly replaced Nhlanhla Nene as Finance Minister.
In our Fixed Income hedge fund, we have taken steps to protect ourselves from a potential pullback in the bond market by purchasing puts as protection but are still well positioned to benefit if positive structural reforms extend the bond rally.
Despite the equity market trading at relatively low PE ratios (looking very cheap), we do not think there will be a wholesale switch from bonds into equities and look to international investors to continue to invest in our local bond market, keeping prices elevated.