Quarterly Commentary - Q3 2021

Why inflation-linked bonds don’t always beat inflation – and why we think they’re currently attractive

Inflation affects us all, both as savers and investors. Ultimately, we’re trying to preserve the real purchasing power of our savings into retirement. Now consider that inflation-linked bonds (ILBs) are the only asset class to offer long-term protection against inflation. Not only is the redemption value of an ILB continually adjusted to account for inflation, but its yield (interest rate) – which is set as a percentage of this value – is specified in real (above-inflation) terms (e.g. inflation +2%). Does it not then make sense to utilise this asset class to the full extent in an income fund, where protecting against inflation is an absolute priority? Or as a diversified source of return in a multi-asset fund, which generally targets inflation-plus outcomes?

Well, it turns out that there’s more to consider than the return stated on the tin. In fact, it may surprise you to hear that ILBs have underperformed inflation for the past six years. This is because the real yields offered by ILBs change over time, and if yields rise – as they have over this period – bond prices fall.

Current ILB yields are very attractive

10-year ILBs are currently offering a real yield of 3.64% – up from a yield of under 1% at the end of 2012. In addition to this high real yield and inherent inflation protection if held to maturity, government ILBs are also risk free if you believe the government can print money to repay its debt.

Why are these yields so high, and what is the risk that they continue to rise and further detract from ILB prices? We believe that a significant amount of this risk is already priced in.

Over the longer term, there should be a close link between economic growth and real yields, as the real return earned on assets should decline when the economy slows down and interest rates fall (or conversely improve when the economy grows and interest rates rise). However, this has not been the case in recent years. In contrast to rising real ILB yields, real GDP has been declining, with the gap between the two recently reaching extreme levels.

Interest rates have also declined to all-time lows. Local real repo rates have recently become negative due to the South African Reserve Bank (SARB) cutting interest rates by 300 basis points during the COVID crisis. In fact, the gap between the 10-year real yield and 10-year real repo is at all-time highs.

This anomaly points to a dislocation between the real return on assets in the government sector and the real cost of capital in the private sector, more commonly known as the ‘crowding out effect’. Weak economic growth and fiscal deterioration due to rising debt levels have increased the cost of financing in the government sector, while economic and investment activity in the private sector remains subdued and corporate credit remains scarce.

Longer-term gains are possible if market anomalies abate

A negative real policy rate is a sign of very loose monetary policy. Given that the SARB and other central banks globally have started to remove their extraordinary monetary support as economies recover from their lockdown-induced recessions, investors have started to price in rate hikes in the years ahead. This process is likely incomplete, and real rates may increase further.

While this unfolds, the repricing of real yields as a result of policy rate increases may dominate shorter-term returns. However, if we look over the longer term, we know that a real yield of 3.6% offered by a 10-year ILB is very attractive relative to the long-term average. Although we don’t know when real yields will revert to fair value, we know that even a small decline in this yield will have a very positive impact on ILB prices, and therefore on overall returns.

At current levels, ILBs are likely to be valuable portfolio additions

We have been including more inflation protection in our funds for a while now. Inflation rates reached all-time lows during the COVID crisis and have started to accelerate. As the economy recovers and if the reform programmes set out for various industry sectors start to take shape, GDP growth should also accelerate. This could mean that the gap between real yields and real economic growth starts to close, as fiscal concerns abate. Even if it doesn’t, earning a yield of 3.6% above inflation on a risk-free government bond for the next 10 years is certainly a decent return for any income fund, and a solid contributor in a multi-asset mandate. On a balance of probabilities, it is also likely to beat most private sector asset alternatives in the bond space.

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Portfolio Manager: Henno Vermaak

Portfolio Manager

Henno joined Granate in July 2019 as an Executive Director and Investment Professional. He founded Capensis Capital (now a subsidiary of Granate) in 2016. Prior to this, he was a portfolio manager at PSG Asset Management, where he was responsible for the PSG Global Flexible and PSG Global Equity funds.

Qualified actuary
CFA Charterholder
BCom (Hons) from the University of Stellenbosch