"We have often written about the margin of safety we demand from equity investments. This prerequisite should ensure that we stay way clear of equities when they trade at grossly inflated prices, i.e. we avoid the equity bubbles. It is not only shares which can pose this trap. In February 1637, during the famous “Tulip Mania”, some single tulip bulbs sold for more than 10 times the annual salary of a skilled craftsman. Any asset class can be grossly overpriced, even cash. To ensure that our clients don’t suffer the permanent loss of capital which results from the bursting of asset bubbles, “margin of safety” transcends our entire asset allocation process.
In earlier Angles, we discussed how we determine whether an equity investment offers a sufficient margin of safety. But how would one go about determining whether bonds offer a margin of safety?
A first question could be: What could drive bonds to inflated levels?
There are mainly three possible scenarios:
Firstly, domestic yield greed. When cash rates drop yield seekers tend to move up the risk ladder into bonds. The lower the rates on cash, the more drastic this migration.
Secondly, international yield greed. Investors could be driven into, for example, South African bonds when the yields on their domestic bonds become relatively unattractive.
The last scenario is a flight to safety. Frightened investors tend to seek safety in government bonds. Decisions are no longer driven by rational yield comparison, purely the fear of capital loss. During these periods, return of capital becomes more important than return on capital.
The next step would be to consider whether any of these scenarios currently prevail. We think so, in fact we think all three prevail.
Interest rates in South Africa are currently at record low levels and investors desperate for yield have moved from cash into bonds.
Government bonds in many countries in the Western World are yielding near zero and foreigners have been snapping up emerging market bonds, like our own, yielding significantly higher rates.
Concerns around defaults in Europe have drawn investors to the government bonds of safe haven countries like the US and the UK.
The third bullet does not seem to have bearing on domestic bonds, but on closer investigation it seems that our bonds have moved in step with these bonds over time.
Although the South African bonds still yield much higher absolute rates, this difference is currently entirely explained by South Africa’s credit risk premium and the inflation differential:
US 10 Year Government Bond yield + SA Credit Spread (USD) + Inflation differential ≈ SA 10 Year Government Bond yield.
In numbers:
1.57% + 1.37% + (4.9% - 1.4%) = 6.44% vs. 6.62% yield on SA 10 Year Government Bonds.
In more simple terms: Ignoring country specific risks, our domestic 10 Year Government Bonds are priced on par with their US equivalents.
Another purely quantitative measure of the margin of safety offered by bonds is portrayed in the below chart.
The chart indicates by how much the bond yield needs to shift (bond prices need to fall) for investors to have been better off in cash over a 12 month period. So beyond the gold line the higher yield is negated by capital loss to such an extent that cash would offer a better total return. Clearly the margin is thin, 32.5 bps at the widest point.
We are not advocating that the South African bonds are the tulips of our time. We are, however, finding more margin of safety at selected equities and therefore our asset allocation funds are allocated accordingly."
The PSG Angle is an electronic newsletter of PSG Asset Management.
REF : Paul Bosman
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