Making Sense of Inflation Linked Bonds and Lower Real Yields

Another Gem of an article from PSG Asset Managment:



"The inflation linked bond market has been an interesting place over the last year. At the end of July 2012, the inflation linked bond index (IGOV) had returned a healthy 9.56% year-to-date and over 12 months, the index has generated 16.70%. This return is a combination of falling real yields and a healthy inflation uplift over the period.


We witnessed the first ever move to negative real yields in the R189 government bond in November last year. The R189 yield moved as low as around -0.70% before correcting recently to a modest +0.25%. This can be partially attributed to the recent inflation peak and the distortion that month-on-month inflation rates provide to very short dated inflation linked bonds. However, it doesn’t change the fact that bond holders were prepared to earn negative real rates on short dated real investments. The yields on the linkers in the belly of the curve have also fallen – where the R212 and R197 had ranged in yield between 2.20% and 2.80%, there has been a structural break lower to the 1.50% region. In the long end of the curve, the R210 and R202 have also moved from a stable range of 2.20% to 2.80% to around 1.90% and 2.10% respectively.

The actions of the South African Reserve Bank need to be understood to fully understand what is driving the short end of the inflation linked yield curve. The penultimate repo rate cut by the SARB in November 2010 left the repo rate at 5.5%, and it remained there until the surprise rate cut of July 2012. For most of 2011, we watched CPI rise, having bottomed out at 3.2% at the start of Q42010 , to a peak of 6.3% in Q1 2012. What this meant was that the rise in CPI, coupled with a stable repo rate dragged the real repo rate to a low of -0.80%. The SARB’s willingness to tolerate inflation above the upper end of the 3% to 6% target inflation band initially was interpreted as a policy error. However, the SARB correctly anticipated that the cost-push pressures driving CPI, the lack of demand pull pressures and the weak global economy would lead to a decline in inflation. This decline in inflation took the real repo rate back to 0%, and in the space of one month, we have watched a surprise rate cut take that real repo negative again, only to see a spectacular decline in CPI to 4.9% (vs. a market expectation of 5.2% and a previous print of 5.5%). The nett result is that the real repo rate is marginally positive at 0.10%.

Why is this important? The willingness of the SARB to tolerate a lower / negative level of real interest rates has important implications for inflation linked- and nominal government bonds. The July rate cut confirmed a mindset shift which suggests that, while remaining a flexible inflation-targeting central bank, stimulating growth and reducing unemployment are important secondary outcomes for the SARB. This means that the SARB is likely to keep real rates lower for longer, and will also accept inflation outcomes closer to the top of the 3% to 6% target band, rather than aim for 4.5% which is the mid-point of the target band. In a global environment of low policy rates and quantitative easing, positive real yields are harder to find. This seems to suggest that investors will actively seek out those economies where yield is still available, and South Africa seems to qualify, both in the nominal and inflation-linked space. What is unusual is that ordinarily, when inflation falls, inflation linked bond yields rise, as investors require less protection from the risk of inflation. However, the fact that South Africa’s real yields have rallied into falling inflation suggests a change in mindset.

Over the year ahead, we will need to assess whether or not the move lower is the beginning of an era of structurally lower real yields for South Africa. Conversely, we will need to monitor the extent of the global recovery, in conjunction with South Africa’s own attempts to generate significantly higher growth rates and to make a dent in our stubbornly high unemployment rate. Only once we sense that success has been attained on these important levels can we begin to contemplate a return to higher real yields."


written by Alastair Sellick

"The PSG Angle is an electronic newsletter of  PSG Asset Management"




Kind Regards








Steven







Steven Morris Chartered Accountant (SA)
3 Bickley Road
Sea Point
Cape Town
8005



Mobile :+27 83 943 1858
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E-mail : steven@global.co.za
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