Global bond investors have done well over recent years as interest rates have trended lower, driven by falling inflation rates and expansionary monetary policies within developed markets. South African bond investors have benefited from this trend, but to a lesser extent, due to country specific risks that readers are familiar with.

The Allan Gray Bond Fund has performed well in this environment, outperforming inflation and its benchmark, the All Bond Index (ALBI), over most time periods. This is pleasing, but hides an important aspect of performance, namely that these returns have been delivered at below market risk.

One way to measure this is the volatility of returns around the mean, or standard deviation. The Fund’s standard deviation has been about 20% lower than that of the benchmark over recent time periods. Put another way, the Fund’s returns have been more stable. Although stability is not always a priority for investors with a long-term investment horizon, it is important for those who value the consistent income that the Bond Fund provides.

The maximum drawdown, or loss, over any 12-month period is another indication of risk. This is easier to understand and more relevant to investors, since it represents an actual reduction in the value of their investment. The Fund’s maximum drawdown over any 12-month period (the lowest annual return) is -2.6%, which occurred between January 2015 and January 2016. Any loss is disappointing, but the Fund’s conservative positioning meant it outperformed most similar investments over this period. The price on the 10-year government bond (R186) fell by 14%, while the ALBI returned -5.6%. Fortunately, the Fund’s drawdown has been more than recovered since January.

The past is no guarantee of the future, but we aim to continue delivering above market returns at below market risk. Our views outlined in previous commentaries remain similar, and we continue to limit risk in the Fund given current uncertainties. The Fund’s duration is materially below benchmark at 4.8 years, and the Fund holds large positions in liquid government and money market securities.

The Fund reduced exposure to long bonds during the quarter and the proceeds were invested in short-term bank deposits.

Commentary contributed by Mark Dunley-Owen

Two notable developments during the quarter were the rating agencies’ decisions to maintain South Africa’s investment grade status, and the UK referendum vote to leave the EU. Both were positive for bond yields. South African bonds regained the losses suffered in December 2015, while developed market bond yields made historic lows on renewed demand for so-called safe haven assets. The average 10-year bond yield for the large four developed markets (US, UK, Germany and Japan) is now close to 0.5%.

We remain committed to our long-term, fundamental investment approach. This suggests that many fixed interest investments have substantial downside risk with limited upside potential at current levels.

Consider for example that the yield on the 50-year Swiss government bond is now negative. It seems unlikely that a negative return is a good investment outcome over the next 50 years. So, why are investors buying such bonds? We don’t know, but we suspect they are short-term orientated with confidence in their ability to time the market and sell before yields start rising. We don’t claim to have such ability; instead we try to understand the major fundamental factors over the long term. One such factor is inflation. Global inflation is currently low, which argues for low nominal bond yields, but we would be surprised if inflation remains at current levels over the next 50 years. If we are right, a reversion to historical averages would mean substantial losses for holders of long-duration Swiss bonds.

In South Africa, the yield on the R2023 government bond that matures in February 2023 is now lower than the yield on one-year bank deposits (negotiable certificates of deposit or NCDs). Investors should question whether they are being compensated for taking on the extra duration risk of a seven-year rather than a one-year instrument. An argument for doing so would be an improvement in macroeconomic fundamentals that justifies lower long-term yields. Yet South Africa’s fundamentals remain weak, and have arguably worsened. GDP growth is close to zero, government debt is high with no obvious means to reduce it, and political uncertainties are escalating ahead of the local government elections. It seems sensible to limit risk in this environment.

The Fund remains below benchmark duration with almost half the portfolio invested in liquid money market instruments and government securities. During the quarter, we reduced exposure to the middle of the curve following the rally in yields. We increased exposure to short duration bank NCDs that offer reasonable real yields, and long duration government bonds that we believe have relative yield support.

Commentary contributed by Mark Dunley-Owen

South African bonds rallied over the quarter, regaining some of the December losses following the firing of the finance minister. The yield on the generic 10 year South African government bond is now around 9%, or 2% in real terms. This does not offer much protection relative to the 20 year average real yield of 4.2%, particularly considering negative developments over the last year.

A South African sovereign ratings downgrade to below investment grade is probable unless there are positive political and economic changes. Bond yields already price in some, but not all, of this downgrade risk. For context, Brazilian long bond yields increased by about 400 basis points during 2015, during which the country was downgraded to junk. South African long bond yields are about 200 basis points higher than their 2015 lows.

Developed market bond yields remain low. According to Bloomberg, about 20% of the global sovereign bond market by value now has a negative interest rate. By way of example: the German or Swiss or Japanese government borrows US$101, pays no interest and repays US$100 on maturity. The government's net cashflow over five years is +US$1, in other words, the government makes money by borrowing. Compare this to the South African government's net cashflow of -R43 on a R100 bond over five years, or the Ghanaian government who pays around three times more than that on their local currency bonds. These differing incentives to borrow should have an important impact on future debt levels; if nothing else, the likes of South Africa and Ghana will need more compelling reasons to increase their debt than the likes of Germany, Switzerland or Japan.

South African corporates are struggling to issue bonds. A number of banks failed to raise their targeted amounts despite offering wider spreads. Few non-bank corporates have issued except for commercial paper. They seem reluctant to accept higher market spreads, preferring to access bank funding or wait until market conditions improve.

The Fund offers a yield pickup compared to the All Bond index , with lower duration risk. Our investment stance remains cautious and there was no material fund activity over the quarter.

The sudden and unexpected decision by President Jacob Zuma to dismiss Finance Minister Nhlanhla Nene had an extremely negative impact on the rand and on bond prices. South Africa faces difficult fiscal challenges. Fuelled by generous wage increases for public servants and rising interest costs, spending by government is growing rapidly at a time when tax revenues are being adversely affected by a weak economy. Nene was doing a good job in very difficult circumstances. The subsequent appointment of Pravin Gordhan as finance minister ended the immediate market panic which followed the President's decision, but sentiment remains extremely fragile.

Over the past year Brazil has experienced a serious financial crisis, and has been subject to continuing downgrades by the rating agencies. Investors fear that South Africa will follow a similar path. If further ratings downgrades are to be avoided, the government will have to stick to its expenditure ceiling and tax increases seem inevitable. At least in the short term, tax increases are bad for economic growth and will further aggravate South Africa's economic malaise.

At its December meeting the US Federal Reserve Board at last abandoned its zero rates policy and embarked on a programme of interest rate normalisation. This event was widely expected and there was minimal response from the markets. However, as US rates normalise, it will become increasingly difficult for other central banks to keep their rates at zero. Accordingly, this probably is the start of a global shift to higher interest rates. The South African Reserve Bank has also been increasing its rates and, given the inflationary shock from recent rand weakness, further increases are probable.

We have long maintained the duration of the Fund significantly below that of its All Bond Index benchmark because we have been concerned about the impact of rising economic and political risks. Unfortunately, in the meltdown following the dismissal of the finance minister, all bond investors have lost money. It could be argued that at close to 10%, long-dated South African bonds now offer yields which compensate for these risks. However, while the Fund does hold some of these high yielding longer-dated bonds, its duration continues to be lower than that of its benchmark. The investment stance of the portfolio remains unchanged.