Prospects for domestic fixed-interest assets and other options going forward

Dr Prieur du Plessis, Plexus group chairman, says the SARB’s move was not only welcome but necessary to add impetus to the struggling South African economy. “While South Africa unofficially emerged from the recession in the fourth quarter of 2009 and growth is likely to accelerate, recovery remains fragile,” he says.

Interest rate sensitive assets reacted positively to the unexpected rate cut. The South African All Bond Index ended 1,4% up for the week, with the entire yield curve declining after Thursday’s announcement (see accompanying graph). The listed property sector also benefited from the move with a return of 2,2% for the week. However, the most important question remains: what are the prospects for domestic fixed-interest assets going forward?

According to Du Plessis, foreigners have still been relatively big buyers of South African bonds this year, with net foreign purchases totalling R12,7 billion. “Foreigners are notoriously fickle investors and, with the latest rate cut, the local bond market has become less attractive,” he says.

“There is also a very real threat of the global economy going into a double-dip (W-shaped) recession due to, among other things, China’s tighter monetary policy over the past few months,” says Du Plessis. This will obviously spill over to other emerging economies and especially commodity-based economies such as South Africa.

“While lower growth traditionally leads to lower bond yields (and rising capital values), this is not necessarily the case with bonds in emerging markets, as yields rise when global economic growth slows and vice versa. Emerging market economies are highly geared to the global economy and commodity prices. During global economic downswings the risks of investing in these economies increase, as downside pressure mounts on important economic variables such as their current accounts and currencies,” he explains. “If global growth should stall and, worse still, go into a double-dip recession, this may well spark a big sell-off in our bond market by foreigners,” warns Du Plessis.

The yields on domestic bonds are higher than the money market – the current yield on the All Bond Index is 9,0% versus the money market’s 6,5% or less. However, neither asset class looks too attractive right now, especially on an after-tax basis. With the risk of capital losses on bonds also a potential risk, Du Plessis believes fixed-interest investors should stick to flexible income funds, where the portfolio manager actively manages the maturity of the portfolio and strives to limit capital losses.

Another fixed-income option for investors is a portfolio of variable-rate preference shares. These preference shares pay dividends, the rate of which is linked to the prime interest rate.

“Although last week’s rate cut obviously resulted in a decline in the dividend yield of preference shares, most of these shares still offer a higher yield than the money market and they have the added benefit of tax-free dividends,” says Du Plessis. “The current dividend yield of preference shares varies between 7,2% and 10,4%. For investors paying the maximum marginal tax rate of 40%, this equates to a pre-tax yield of between 12% and 14,6%.”

Furthermore, preference shares are still trading at a discount to their original issue prices, which results in an increase in the effective yield. Although preference share prices vary, price volatility does not influence the investor’s income stream as dividends are based on issue prices and not market prices.”

The last option for investors is property that offers an income stream comparable to bonds but with potential for much higher growth (or losses) in capital value than that of bonds. “While the recent interest rate cut should boost both economic growth and the prospects for improvement in the property market, the prices of property instruments have experienced equity-type volatility in market corrections,” warns Du Plessis. “If a double-dip recession materialises, listed property instruments will be affected negatively. Only investors with a long-term time horizon of at least three to five years should currently consider an investment in listed property.”

Article by: www.eprop.co.za