Don't be greedy: The pursuit of real returns through Fixed income

19 March 2024

Why it makes sense to opt for more conservative fixed income funds in the pursuit of risk-managed, inflation-beating investment returns.

Everyone would like to have an investment portfolio with superior returns that shoots the lights out. But truth be told, superior returns often come from taking higher risks. As individuals, how do we invest tactically and safely to beat inflation instead of simply saving a few rands for a rainy day?

Tlhoni Komako, Fixed Income Portfolio Manager at Ashburton Investments, believes it is important to start with clear goals and time horizons when you build your investment portfolio, and to look at various asset classes including more conservative fixed income funds. "Being clear on what you want to achieve will help you understand the risks you can afford to take and how to structure your portfolio across asset classes that make sense for you.” 

The first priority when investing is to beat inflation

Sam Ewing famously said, “Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair”. Inflation is a financial risk that investors always want to outperform, says Komako.

To demonstrate the relationship between inflation and investing, Komako explains: “The Consumer Price Index (CPI) was 5.1% year-on-year in 2023. The past year we’ve also seen some attractive returns from stocks and bonds. The All-Bond Index (ALBI) showed a total return of 9.7% in 2023, outperforming the FTSE/JSE All Share Total Return Index (ALSI) which returned 9.3%. Over the same period, the ALBI had a 50-day moving average daily volatility high of 12.6% while that of the ALSI was 19.5%. The ALBI’s real return was 4.6% and the ALSI was 4.1%, while over two years the real returns of bonds were 0.8% and equities barely made it with 0.2%,” says Komako.

It is because of these complexities that it is always advisable for investors to consult professional financial advisers, when seeking inflation-beating returns, instead of diving into stocks and bonds uninitiated.

Finding opportunities in fixed income investing

When it comes to beating inflation, Komako believes investors need to look at fixed income funds. There are various kinds of fixed income funds, but essentially these are lower risk funds that pay out fixed interest rates to investors on a fixed schedule.

In South Africa, fixed income funds on average delivered 4.1% real return over a one-year period and 1.3% real return over a two-year period. "What this means is that they delivered similar returns to bonds and equities in the one-year term, but over two years it can start meaningfully defending investors against inflation compared to the other two asset classes. This is impressive considering how much less volatile these funds are in a time when we saw the highest inflation prints of the decade, with a peak of 7.8% year-on-year headline inflation print seen in mid-2022.”

Source: Bloomberg, ASISA, Ashburton Investments (data as of 31 December 2023)

“Looking at Figure 1, we can see how different asset classes compare in terms of real returns over one, two and five years.  We can see how volatile the All-Bonds and All-Share Indices have been over two years compared to the traditional fixed income funds, and yet they underperformed.”

X marks the spot in ‘CPI + X%’

“Given how the South African Reserve Bank (SARB) has fought to bring inflation within the target range of three to six percent, most economists are forecasting inflation to average at around five percent over the next two years. Inflation forecasts are influenced by fluctuations in food and fuel prices, which could also trigger higher wage demands.”

Looking at Figure 2, Komako explains that inflation will gradually move towards the mid-point of the SARB’s inflation target. “Fixed income funds (including Money Market funds) are still expected to deliver between 8.8% and 10.5% this year and around 8.3% to 10% in 2025, given interest rate cuts are expected within the same periods. A hanging opportunity of between 2.5% to 5% real rate of return is attractive for those investors who don’t need to take excessive risk over the next one to two years.”

“But yes, for the long-term investor (who is young) with some risk appetite and who is not concerned about short- to medium-term volatility, bonds and stocks might be ideal over the five-year term.”

Making the best decisions for your retirement

For individuals approaching retirement, retirees, pension funds, the risk-averse investors looking to save that deposit for a house or an asset, and those planning to leave a financial legacy or generate a reliable stream of income, various types of income funds can be well-suited for their portfolios in periods of economic uncertainty.

“Though the potential for capital appreciation might be less compared to equities over a long period, your investment strategy can and will likely change over time as your goals and budget change. So always monitor and rebalance your portfolio. It’s all about your investment needs in this phase of your life, which you should make clear to yourself and your financial adviser.

“All in all, greed can cloud your judgement and lead to taking unnecessary risks which can result in significant drawdowns. Cryptocurrency is a clear example of this kind of risk. It is important to achieve a balance between different asset classes. A great capital allocator once said, I fire two portfolio managers, those who outperform by too much and those who underperform by too much. Because one is taking too much risk and the other is incompetent. Investors can find the sweet spot of safeguarding their investments with real returns without taking significant risk.”