Fixed income investing has long been a cornerstone in the pursuit of alpha by asset managers. Recent data emphasizes the heightened activity in secondary bond trading markets, reflecting the energetic nature of this sector.
Drawing on over three years of experience in fixed income and equity valuations, I have observed several recurring misconceptions within the field —issues that I aim to clarify here.
The commitment to wealth preservation and creation among asset managers in Namibia is truly commendable. This focus not only benefits the average Namibian, ensuring they have a reliable income stream upon retirement after years of hard work, but it also bodes well for institutions like the Government Institutions Pension Fund (GIPF). The pursuit to outperform benchmarks and deliver compelling returns for those entrusted with GIPF mandates is encouraging indeed.
As we enter an interest rate cut cycle driven by cooled inflation, consumer spending is expected to increase, leading to a surge in GDP growth. This environment compels asset managers to bid competitively in the Bank of Namibia’s bond auctions to secure higher yields.
Locking in these yields now is advantageous, as declining interest rates will cause bond yields to decrease, pushing bond prices higher and potentially resulting in capital gains depending on the type of fixed income instrument and its duration. This scenario can significantly enhance portfolio performance, a fact that asset managers are eager to showcase in their client fact sheets.
One prevalent misconception is focusing solely on the annualized return of a bond within the investment time horizon. While this is critical, analysts must research deeper to assist portfolio managers in understanding the gradations of interest rate risks and bond returns. As interest rates drop, bond yields decrease, leading to a rise in bond prices—a relationship we’ve already established. However, there’s more to consider. Two key risks must be evaluated before calculating annualized returns: price risk and reinvestment risk.
Price risk refers to the possibility of bond prices falling when yields rise, whereas reinvestment risk involves the potential for yields and reinvestment rates to decline, which would cause bond prices to rise. Understanding and mitigating these risks is crucial for asset managers, particularly when deciding whether to hold a bond to maturity or sell it beforehand.
How can you strategically structure your portfolio to capture the benefits of both yield and price appreciation? To start, analysts must rigorously analyze and price bonds to determine whether they are fairly, over-, or under-valued in the market, ensuring that capital is effectively utilized. In my recent valuations, I’ve identified three fixed income instruments with significant potential: certain bonds in the middle segment of the curve, Negotiable Certificates of Deposit (NCDs), and inflation-linked bonds. These instruments can generate superior returns for a portfolio. Yet, this is just one aspect of the strategy.
Another crucial l factor is modelling the supply of bond issuance by the Bank of Namibia to understand its impact on bond yields and prices. We know that the central bank must adhere to its borrowing plan as outlined in the borrowing calendar. As interest rate cuts become more pronounced, the cost of borrowing decreases, giving the Bank of Namibia flexibility to overallocate certain instruments during auctions.
For example, the central bank might decide to increase the issuance of 10-year bonds while keeping the supply of other bonds constant. All else being equal, this increase in 10-year bond supply would drive their yields higher relative to other terms, thereby steepening the yield curve.
What does this mean for portfolio managers? It might prompt them to increase their holdings of these instruments to maintain strong performance. However, continuously buying more of the same instruments to prop up portfolio value isn’t always the best strategy. Alternatively, while a fund-of-funds structure could be employed to distribute risk and mitigate negative performance, ensuring that a fund’s fact sheets remain attractive, I would caution against this approach, as it may be considered unethical.
Instead, I recommend that analysts rigorously explore their valuation models, experimenting with various scenarios to uncover the best investment strategies that yield strong returns. This perspective is intended not as investment advice but as an educational guide for market participants, emphasizing that there is more to consider than simply “locking in high yields†and encouraging the crafting of a well-rounded strategy that adapts to evolving market conditions.
*Arney is a young investment professional with over 3 years of experience in economics and finance, specializing in fixed income and equity research analysis. He can be reached at arneytjaro@gmail.com.
The views and opinions expressed in this article are solely those of the author and do not necessarily reflect the official policy or position of any associated organization, employer, or company.
