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Where is the risk, in bonds or equities?


Born in Cape Town, Natale Labia lives in Milan, Italy, and writes on the economy and finance. Partner of private equity firm Lionhead Capital Partners. MBA from Università Bocconi. Supports Juventus.

The perceived wisdom that bonds are safe and equities are risky has led most retail investors and savers into buying the typical split of 60/40 unit trusts, where the 60% in equities will result in long-term capital growth with a trade-off of higher volatility, and the 40% in bonds will preserve capital and result in a steady yield and income stream.

First published in the Daily Maverick 168 weekly newspaper.

Ask any old-fashioned financial adviser what the best portfolio should be to guarantee growth and capital preservation, and it is likely to be something along those lines.

This perceived wisdom may, however, have flipped on its head.

Bond yields are on the rise. In the US, Japan, China, Australia, Europe and the UK, 10-year bond yields are at their highest levels in nearly a year.

One of the least recognised effects of low global rates is the ability for investors to experience major capital loss on bonds, particularly for those invested in developed world bonds and for those at the longer end of the curve (up to 30 years).

While the US 10-year Treasury yield at 1.6% might not sound like a lot, it has trebled in the past six months. What many investors might forget about this idea of bonds being safe is that in such a low-yield environment, even seemingly trivial increases in yields can have profound consequences of capital loss.

For the past 40 years the tide has been one way. After peaking at almost 16% in 1981, the US 10-year Treasury yield has been in an almost continuous bull market. Never mind equities; if you had put your portfolio in the US bond market in 1980 and forgotten about it you would be up hundreds of percent.

The question now is: where to from here? While the US 10-year never quite turned negative like many other developed world bonds, it wasn’t far off – and with signs that the US economy is starting to turn the corner and inflation may be creeping back into the system, the implications for investors in bonds could be profound.

SA investors, particularly those in such typical off-the-shelf 60/40 products, are not immune to this. While still far off the all-time low of 6.7% in 2012, the SA 10-year bond yield is far from showing good value.

Taking into account the essential macroeconomic headwinds facing the country, the current yield of under 9% is hardly compelling. An emerging market wobble, the rand blowing out and foreign investors thinking twice about their exposure to an emerging market when bonds in the US are showing reasonable yields mean that the SA 10-year at levels of 11% or 12% is not inconceivable.

What this would do to the face value of these holdings in a 60/40 portfolio would be profoundly negative. All is not over for the 60/40 portfolio, however. In the developed world, investors can still count on the largesse of central banks to ride to the rescue. This week the Australian central bank and European central bank pledged to intervene further if rising rates threaten a recovery.

Holders of SA debt are not so lucky. The South African Reserve Bank has, rightly, pledged that it will not intervene in such open market operations and quantitative easing to steady the bond market. SA is, fundamentally, an emerging market that does not have the privileges of a developed one.

South African investors would do well to take note. This may not be the worst time for maybe a little extra cash, a bit more gold and some good-quality value equities. DM168

This story first appeared in our weekly Daily Maverick 168 newspaper which is available for free to Pick n Pay Smart Shoppers at these Pick n Pay stores.


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