BODO: Why you should shift investment portfolio to bonds

Earlier this month, in my July 3rd article I made a ‘buy’ call for stocks in the second half of the year.

My call was based on the fact that the violent sell-off recorded in the second quarter of the year had waned and stock market valuations had bottomed out, presenting a perfect buy window for bargain hunters.

I’m now downgrading my earlier buy call on equities to ‘watch’. If you remember well, I had coated the ‘buy’ call with some three risks. One of the risks, interest rates, is about to start crystallising, hence my downgrade.

Interest rates are already pointing north. Yields in July’s primary auction edged up by one hundred basis points.

The Central Bank of Kenya, (CBK) through its open market operations, is picking term auction deposits (TADs) at 14 per cent levels, which is an increase of nearly four percentage points since July began.

Kenya Banks Reference Rate (KBRR) was adjusted upwards by a hundred basis points this month and banks are already giving upward repricing of loans notices to their variable-rate borrowing clients.

And with the exchange rate still volatile, there is a high likelihood that a majority of CBKs monetary policy committee (MPC) members could vote for a third rate increase in their August 5th meeting, as the apex bank sweats to cool the market.

Aside from exchange rate volatility, inflation is also posing significant risk to price stability, and is actively tracking the depreciative trend of the shilling.

This is because, and as I have repeatedly pointed out before, the exchange rate remains a significant pricing component of pump prices and hence basic commodities. Consequently, rates could peak at 17 per cent levels before starting to glide down.

However, I’m not putting any timeline to this. Historically, short-term interest rates have had an inverse relationship with stocks.

One simple explanation for this phenomenon is the fact that whenever short-term rates rise, a yield curve inversion occurs, thereby crowding out risky assets (stocks included).

This then results into a flight into fixed income asset classes, which is often accompanied by disorderly and sometimes violent sell-off of risky assets. At the current levels, interest rates are already hurting stock market valuations.

Month-to-date, stock market valuations are down by seven per cent while the NSE-20 Share index has declined by eight per cent peak-to-trough.

And the decline is accompanied by strong volumes, which is a further confirmation of an underlying weakness in the market.

Any more rise in rates, especially in the quantum of two to three percentage points, could further narrow betting spreads in the market. Which is why, in addition to downgrading my earlier buy call on equities to watch, I’m also calling for a portfolio shift towards bonds.

At the current valuations, bonds are looking juicy and could offer some refuge from the gliding stock market valuations.

And, if the MPC votes for a third rate rise, a yield curve inversion could follow, making bonds even more attractive, from a purely coupon perspective.

Mr Bodo is an investment analyst.