South Africa saw the formal introduction of inflation-linked bonds (ILBs) into the domestic listed bond market in March 2000, with the introduction of the R189 with a real coupon of 6.25% (matured 31 March 2013).
Before that, inflation-linked instruments were trading in the domestic market but those trades occurred primarily in the unlisted debt market dominated by local banks.
Initially ILB auctions were monthly and auction sizes were small, which meant the purchase of these bonds was basically a buy and hold strategy. However, the domestic listed inflation linked market experienced significant growth over the past 15 years and auction frequency and size increased over time. Total market capitalisation of inflation-linked bonds listed on the JSE as at 31 May 2016 stands at R520.9 billion, compared to total listed debt of R2 trillion. National Treasury remains the biggest ILB issuer with a market capitalisation of R481.5billion with ten different bonds and maturities ranging from 2017 to 2050. (Issuance of ILBs in the unlisted space continues but the size there remains relatively small.) Thus the market for ILBs has developed to such an extent that investors, especially retirement funds, can consider it a separate asset class and make a separate fixed income asset allocation relative to nominal bonds and cash.
Source: Futuregrowth
So why are ILBs such a great asset for retirement funds? Retirement funds need to pay benefits to their pensioners and normally these benefit payments escalate annually at the rate of inflation. These benefit payments are considered a liability to the pension fund. To fund this liability, the pension fund invests all pension premiums received in investments that, on aggregate, must at least keep pace with inflation.
So the great historic performance of ILBs (per chart above) have three major sources of return:
- Capital component – capital gains and losses arising from movements in the real yield
- Accrual Component – interest accrual based on the real coupon rate
- Inflation carry – annualised rate of change in inflation
The inflation carry is the return component that makes ILBs such an ideal asset class for pension funds. The pension fund especially wants to have this exposure when inflation remains stubbornly high or is rising. In a country like South Africa where the inflation rate has historically been structurally high, the inflation carry ensures that the value of the ILBs is not eroded by inflation. The other great thing about this inflation carry is that you earn it over the life of the bond. What that means is that if a bond issued in 2010 pays a coupon in 2016, the coupon will be indexed (adjusted) by the inflation rate from the date of issue of the bond to the payment date of the particular bond. This will apply to all coupon payments received over the life of the bond as well as the capital repayment when the bond matures.
The sources of return increase when you add yield enhancement from credit assets to the portfolio. It is Futuregrowth’s view that, generally speaking, the yield enhancement from listed ILB credit instruments (e.g.bank and SOE issuers) is generally not sufficient for the specific credit risk. We have decided to instead lever off our nominal credit process to find suitable yield enhancement for all our portfolios, including our yield enhanced inflation-linked bond funds. We then make use of derivatives to ensure that the correct real interest rate risk is present in the portfolios. Over the past few years we have extended our yield enhanced inflation-linked bond capabilities to a number of products as reflected in the table below.
Currency: ZAR/Gross of fees/*Annualised/***Portfolio returns. Supplemental information.
We have been building well diversified credit portfolios for our clients for more than 15 years. The Futuregrowth Yield Enhanced Inflation-linked Bond Fund has more than 100 different issuers. This level of diversity is not available in the listed market. We believe our inflation linked products are well suited to form part of the asset allocation of any balanced retirement fund.
FAIS disclaimer: Futuregrowth Asset Management (Pty) Ltd (“Futuregrowth”) is a licensed discretionary financial services provider, FSP 520, approved by the Registrar of the Financial Services Board to provide intermediary services and advice in terms of the Financial Advisory and Intermediary Services Act 37 of 2002. The fund values may be market linked or policy based. Market fluctuations and changes in exchange rates may have an impact on fund values, prices and income and these are therefore not guaranteed. Past performance is not necessarily a guide to future performance. Futuregrowth has comprehensive crime and professional indemnity in place. Performance figures are sourced from Futuregrowth and I-Net Bridge (Pty) Ltd. GIPS disclaimer: Futuregrowth Asset Management (Pty) Limited (“Futuregrowth), a subsidiary of Old Mutual Investment Group Holdings (Pty) Limited is a specialist investment company which manages the full range of interest bearing and developmental investments in an ethical and sustainable way. Futuregrowth claims compliance with the Global Investment Performance Standards (GIPS®). Contact Futuregrowth at +27 21 659 5300 to obtain a list of composite descriptions and/or a presentation that complies with the GIPS® standards. The investment returns reflected are supplemental information as they are not calendar year returns and are gross-of-fees. Currency: ZAR
