Investors shrug off uncertainty

Political turmoil, the risk of a widening budget deficit, a weakening currency and the prospect of a credit downgrade to junk would usually put investors off a country’s bonds. Not when it comes to SA.

Political turmoil, the risk of a widening budget deficit, a weakening currency and the prospect of a credit downgrade to junk would usually put investors off a country’s bonds. Not when it comes to SA.

The lure of the highest yields among emerging-market peers is proving irresistible, with foreign investors buying a net R18bn of South African bonds in September, the most in a month since March.

That brought inflows in 2017 to R68bn and foreign ownership of the country’s local-currency debt to about 45%, compared with 20% for Turkey and 28% for Russia.

“High real rates, a benign inflation outlook and scope for further easing” of monetary policy could see yields falling in several emerging markets including SA, Andre de Silva, head of emerging-market rates research at HSBC Holdings, said in a report this week that recommended buying South African 13-year rand bonds.

“We don’t see any reason to be cautious,” he said.

The optimism may be misplaced. The governing ANC is embroiled in a leadership battle, while tepid economic growth means tax revenue is falling short of projections, complicating Finance Minister Malusi Gigaba’s task as he prepares to present his midterm budget on October 25.

Any sign of fiscal slippage could break SA’s tenuous hold on an investment-grade rating for its rand debt — and cost the country its place in indices tracked by investors overseeing trillions of dollars.

Once that happens, many of the offshore investors holding about $45bn of the country’s local-currency government bonds may be forced to sell.

Outflows could reach as much as $14bn, according to Bank of America Merrill Lynch.

The bond market has not priced in that outcome, says Absa Bank strategist Mike Keenan, who predicts benchmark 10-year yields could rise above 9% in the first half of 2018. The yield increased two basis points to 8.64% by 11.17am in Johannesburg.

Moody’s Investors Service and S&P Global Ratings, which both have investment-level ratings on SA’s local-currency debt, are reviewing their assessments in November.

With Fitch Ratings having cut its evaluation to subinvestment grade, one further reduction would dump the bonds into the junk category.

“If we are downgraded, we are likely to sell off and see outflows after the event, much like Turkey did,” Keenan says.

“There is increased country risk whether there is a downgrade or not and we believe there is scope for credit spreads to widen and core yields to move higher going into year-end.”

That is not the only risk. Apart from the ANC’s leadership contest, which culminates in an elective conference in December, offshore investors should also be fretting about the rand, which has dropped 3.4% against the dollar since June.

SA’s currency was the worst performer among emergingmarket peers in the carry trade this half and has the highest implied volatility, suggesting traders expect price swings to widen. The rand weakened 0.4% to 13.6229/$ on Thursday.

For now, yields are high enough to compensate for the uncertainty, said Kevin Daly, a London-based emergingmarket portfolio manager at Standard Life Aberdeen, which oversees about $871bn.

South African 10-year bonds have the highest yield among investment-rated localcurrency bonds of emergingmarket nations.

“The leadership contest is a primary event and it looks like it will be a very tight vote, but there won’t be great outflows” regardless of who wins, Daly says. “We don’t think the ratings agencies will be in any mood to move in November until they see what happens at the [ANC] elective conference.”

While foreigners are still happy to take the yield in return for the risks, local investors are wary about the debt, according to Malcolm Charles, a portfolio manager at Investec Asset Management in Cape Town.

Slowing inflation and dovish monetary policy are bond supportive, but the key risk is the mid-term budget policy statement, he says.

“The global environment of low yields in developed nations has also been supportive, but is likely to become less so going forward,” Charles says.

“Local appetite is very negative with the market concerned about the budget.”

WE BELIEVE THERE IS SCOPE FOR CREDIT SPREADS TO WIDEN AND CORE YIELDS TO MOVE HIGHER GOING INTO YEAR-END