Namibia
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Why Bonds Remain a Great Tool to Diversify Local Portfolios

Given the persistent rise in inflation, soaring interest rates and geopolitical turmoil, both shares and bonds struggled in 2022, but the outlook for bonds is positive and bonds still have an important role to play in multi-asset portfolios.

Bonds are a type of financial instrument where investors lend money to either a company or a government for a set period of time, typically spanning several years, and investors receive a fixed rate of interest at regular intervals, usually twice a year.

When investing your money, you have many options which range in asset classes like shares, property and bonds. People often choose multiple assets (multi-asset portfolios) in order to reduce their risk.

One company share may fall in value, but the likelihood of all assets falling at the same time has proven to be unlikely in the past.
For example, the equity portion of your portfolio could fall, but your other assets may hold steady or increase in value, so protecting your overall investment value.

The age-old saying of spreading your risk and not putting all your eggs in one basket holds true. Therefore, it’s important to ensure you have the right mix of asset classes in your portfolio.

So, what do bonds bring to a portfolio?

BONDS AND THE PORTFOLIO

Bonds play an important role in a well-diversified portfolio by helping to reduce volatility (sharp rises and falls) in the value of the portfolio.

In the past, bonds have typically been a stable investment as they generally have less price volatility compared to shares, and act as a capital preservation tool.

They offer a more stable income stream, especially during periods of market downturns and uncertainty.

By investing a portion of your portfolio in bonds, you can reduce the risk associated with more volatile shares.

The appropriate mix of shares and bonds in a portfolio will be dictated by your financial objectives and your attitude to risk. These are areas you need to discuss and agree with your financial adviser.

BONDS IN 2022

Although we typically assume that bonds and share prices don’t move in the same direction, providing a diversification benefit, this is not always the case.

For instance, in 2022, when interest rates were still rising, despite rapidly weakening economic growth expectations, bonds and share prices both fell at the same time.

While such a combination of rising interest rates and falling growth can be expected in most economic periods, it is typically short-lived, because governments (typically central banks) act to try to reduce demand.

However, if inflation is the result of a supply shock (which is the current status quo), rising interest rates are less effective at bringing inflation down and, therefore, interest rates have to rise higher and faster for longer than might normally be the case.

In a usual business cycle, when central banks are raising interest rates to combat inflation caused by excessive demand, companies can expand their revenues.

Typically, bonds struggle while share prices do well. Conversely, when interest rates begin coming down because there isn’t enough demand in the economy, bond prices do well, while share prices may lag due to the lower demand.

Last year was unusual in that both economic growths were declining and interest rates were rising rapidly, leading to a reduction in the diversification benefits between shares and bonds. Remember that inflation in 2022 was driven by an inflation shock and not by excessive demand.

This sharp rise in inflation was as a result of the rapid reopening of the global economy after the pandemic lockdowns, followed by the invasion of Ukraine which resulted in large supply shocks in energy and labour.

Consequently, inflation went up and economic growth expectations started to fall, which is a bad environment for both bonds and shares.

BONDS, A USEFUL DIVERSIFIER?

In light of the background highlighted above, the key question arises, do bonds still play a role in this environment? I believe bonds still have a useful role to play.

While you may feel that with bonds and shares falling at the same time, multi-asset portfolios may no longer provide diversification, there is no need to panic, as I think normal service should resume shortly.

In my view, at some point in the next year, interest rates will begin to come down as inflation starts to fall. This means the usual diversification benefits of bonds should come back to the fore providing their usual diversification characteristics in multi-asset portfolios.

I think we are nearing a peak in both the inflation and rate hike cycle in the United States (US), with the Federal Reserve (Fed) likely to hike at most twice before the end of the year and go on a pause for some time before cutting rates as the US economy is expected to have a soft recession.

With the Fed being the global central bank tapering off rate hikes, this should also result in a peak in the rate hike cycle in South Africa and Namibia, who have hiked rates aggressively to tame inflation.

Following this peak, there is a strong expectation that the South African and Namibian central banks will start to cut rates some time next year, which will provide some respite to the local economy.

Thus, the near to medium term environment bodes well for bonds, with inflation and interest rates falling and global supply chains improving. I expect bonds and shares to perform well and support multi-asset portfolios, as bonds further enhance portfolio diversification and provide stability in an investment strategy.

Furthermore, rate cuts magnify capital gains (given the inverse relation between interest rates and bond prices) for investors looking to invest in bonds.

When one looks at our Namibian bond market, the recent Bank of Namibia auction results indicate that investors are buying both short- and long-term bonds (barbell bond strategy), with both short-term and long-term bonds being oversubscribed.

This is a prudent strategy which I believe will allow investors to lock in gains at both the short and long end of the bond curve, as the curve will start to flatten over the next 12 to 18 months as investors start to price in upcoming rate cuts.

*Arinze Okafor is a qualified investment professional with expertise in fixed income, equity and investment analysis. He currently serves as the chief investment officer of Mopane Asset Management. The advice and opinions provided herein are done in his professional capacity and do not constitute investment advice.