Bond mar­ket in­vestors have been get­ting more than their fair share of un­cer­tainty

SA rally has un­der­per­formed its emerg­ing mar­ket peers, a sig­nif­i­cant change from its out­per­for­mance of most of its peers over the past decade, writes Stafford Thomas

Financial Mail - Investors Monthly - - Contents -

Bond mar­ket in­vestors have been get­ting more than their fair share of what they hate the most: un­cer­tainty. They can ex­pect more of the same.

In­vestors have been taken on a wild ride by bonds since the start of 2015. It was a year which started on a pos­i­tive note with hopes of a sharp fall in in­fla­tion driv­ing the yield on the key 10-year gov­ern­ment R186 bond to 7% in April. It was a mere 45 ba­sis points (bps) from the record low it reached in May 2013.

Then the rot set in. A com­bi­na­tion of fac­tors was at play. First was a slump­ing rand that was to lose one third of its value against the US dol­lar in 2015. Adding to bear­ish sen­ti­ment was a fall from favour of emerg­ing mar­kets in gen­eral, on the back of plung­ing oil prices and signs of a wors­en­ing eco­nomic slow­down in China.

The com­bi­na­tion sent SA bond yields soar­ing. By early De­cem­ber the R186 was trad­ing around the 8.6%-8.8% level.

There was more bad news to come for SA bonds, cour­tesy of Pres­i­dent Ja­cob Zuma’s fir­ing of fi­nance min­is­ter Nh­lanhla Nene and the ap­point­ment of an un­known back­bencher, David Des van Rooyen, in his place on De­cem­ber 9. A con­fi­dence­shat­ter­ing move on a grand scale, it re­sulted in SA hav­ing three fi­nance min­is­ters in four days.

Within those few days the R186 spiked to 10.65%, equalling the high­est level reached dur­ing the global fi­nan­cial cri­sis in 2008. It left the to­tal re­turn from the JSE all bond in­dex for the year at -3.9%, its first neg­a­tive re­turn since 2009.

A sem­blance of sta­bil­ity was re­stored when Zuma back­tracked and ap­pointed Pravin Gord­han as fi­nance min­is­ter. Also coming to SA’s as­sis­tance was a strong resur­gence in in­vest­ment in emerg­ing mar­kets.

The resur­gence was sparked in mid-Jan­uary by a re­bound in sen­ti­ment to­wards com­modi­ties, thanks to the oil price coming off its low­est level in a decade. Adding mo­men­tum, in Fe­bru­ary China’s cen­tral bank moved to in­crease mon­e­tary stim­u­lus by low­er­ing bank re­serve re­quire­ments.

The big­gest boost to emerg­ing mar­kets bonds came on March 16 when the US Fed­eral Re­serve’s open mar­ket com­mit­tee held the key US Fed funds rate, the equiv­a­lent of SA’s repo rate,

un­changed at 0.4%. It also sur­prised mar­kets by an­nounc­ing that the Fed funds rate would be kept lower for longer than had been ex­pected.

Ac­cord­ing to the Fed, the me­dian of the open mar­ket com­mit­tee par­tic­i­pants’ pro­jec­tions for the fed funds rate is now 0.9% for the end of 2016 and 1.9% for the end of 2017. Both are 50 bps be­low the me­dian pro­jec­tions made in De­cem­ber.

Driven by pos­i­tive de­vel­op­ments, emerg­ing mar­ket bond mar­kets have ral­lied strongly. Re­flect­ing this, the MSCI emerg­ing mar­kets US dol­lar in­dex has ral­lied 20% since late-Jan­uary. The rally fol­lowed a 30% fall in the in­dex in the pre­ced­ing 15 months.

SA bond yields joined in the rally, the yield on the R186 fall­ing back to trade in a range of 9% to 9.6% since early Fe­bru­ary. How­ever, there is lit­tle ev­i­dence to sug­gest that be­yond the boost from the emerg­ing mar­kets bond rally any sig­nif­i­cant con­fi­dence has been re­stored. Even at 9%, the R186’s yield is above the three pre­vi­ous highs be­tween 2009 and 2014 and 50 bps above the level just prior to the fi­nance min­is­ter fi­asco.

If any­thing, the SA bond mar­ket rally has un­der­per­formed its emerg­ing mar­ket peers, a sig­nif­i­cant change from SA’s out­per­for­mance of most of its peers over the past decade. As an in­di­ca­tion, Rus­sia’s 10-year gov­ern­ment bond yield has eased from 10.8% in Jan­uary to 9%. It puts the R186’s yield on, at best, the same level as Rus­sia’s, a coun­try whose sov­er­eign debt rat­ing was rel­e­gated to sub-in­vest­ment ( junk) grade sta­tus in Jan­uary 2015.

There are many po­lit­i­cally driven rea­sons for a lack of con­fi­dence in SA bonds, in­clud­ing Gord­han’s hound­ing by the Hawks, the con­sti­tu­tional court’s rul­ing that Zuma had failed to up­hold the con­sti­tu­tion and the con­tro­versy sur­round­ing his re­la­tion­ship with the Gup­tas. In­vestors may well be for­given for ask­ing: what next?

Adding an­other layer of un­cer­tainty, SA has been star­ing over the precipice of a down­grade of its sov­er­eign debt to sub-in­vest­ment grade sta­tus. Moody’s sur­prised the mar­ket on April 6 when it an­nounced that it was not go­ing to down­grade SA’s sov­er­eign rat­ing. It held its rat­ing at Baa2, though the rat­ing was as­signed a neg­a­tive out­look.

“Not only did Moody’s sur­prise the mar­ket by keep­ing the rat­ing un­changed, but the state­ment that ac­com­pa­nied the rat­ings de­ci­sion was ex­tremely pos­i­tive given re­cent eco­nomic and po­lit­i­cal events,” says Stan­lib chief econ­o­mist Kevin Lings.

Moody’s Baa2 rat­ing is two notches above junk sta­tus. Ac­cord­ing to Lings, the rat­ing agency’s rea­sons for hold­ing its rat­ing un­changed in­clude its view that SA’s eco­nomic growth will grad­u­ally strengthen, and the pos­i­tive fis­cal de­ci­sions be­ing taken by na­tional trea­sury.

But SA is not out of the woods yet. Fitch down­graded SA to BBB- sta­ble two days prior to Zuma’s fir­ing of Nene. BBB- is only one notch above junk sta­tus and Fitch is due to re­lease its next re­view of SA in June.

Of even more con­cern, Stan­dard & Poor’s (S&P) went a step fur­ther, down­grad­ing SA’s sov­er­eign debt rat­ing from BBBstable to a pre­car­i­ous BBBneg­a­tive on De­cem­ber 15. The next down­grade move by S&P would plunge SA into junk sta­tus, a move that would al­most cer­tainly have a pro­foundly neg­a­tive im­pact. S&P is due to re­lease its next re­view of SA on June 3.

As mat­ters now stand the gen­eral mar­ket view is that a one-notch down­grade by Moody’s was at least partly priced into bond yields. It can only be hoped Fitch and S&P will fol­low Moody’s lead.

If this proves to be the case, sta­bil­ity in the SA bond mar­ket yields will de­pend on the ab­sence of fur­ther po­lit­i­cal shocks and con­tin­ued for­eign in­ter­est in emerg­ing mar­kets in gen­eral. How­ever, the emerg­ing mar­ket sit­u­a­tion is far from be­ing with­out high risk. Ham­mer­ing this home, the

Fi­nan­cial Times quotes the In­sti­tute of In­ter­na­tional Fi­nance’s di­rec­tor for cap­i­tal mar­kets, Hung Tran, as warn­ing: “We are pes­simistic be­cause we see no im­prove­ment in the struc­tural prob­lems fac­ing emerg­ing mar­kets. On the con­trary, they are get­ting worse so there is noth­ing to feel good about.”

Tran’s warn­ing will bring lit­tle com­fort to in­vestors in emerg­ing mar­ket bonds. For­tu­nately, for SA in­vestors there are sleep-easy al­ter­na­tives.

Among them are in­come funds. Cur­rently yield­ing around 8%, in­come funds hold the at­trac­tion of pro­vid­ing some cap­i­tal up­side po­ten­tial in a fall­ing in­ter­est-rate en­vi­ron­ment and cap­i­tal pro­tec­tion when yields rise sharply.

An­other al­ter­na­tive is SA trea­sury re­tail sav­ings bonds. Though in­vestors in the fixed in­ter­est in­stru­ments forgo po­ten­tial cap­i­tal gains in a fall­ing bond yield en­vi­ron­ment, there is no risk and yields are gen­er­ous.

On two-year re­tail bonds the yield is 9.2%, on three-year bonds 9.5% and on five-year bonds 9.75%. There are no man­age­ment costs and with­drawals are per­mit­ted af­ter 12 months of in­vest­ing sub­ject to a mod­est penalty fee.

For those who rank the po­ten­tial of an in­vest­ment to de­liver cap­i­tal gains high and be­lieve bond yields will fall sharply, yields of 9% on SA 10-year gov­ern­ment bonds and al­most 10% on 20-year bonds are tempt­ing. But risk-averse in­vestors should think care­fully be­fore plung­ing in.

In­come funds hold the at­trac­tion of pro­vid­ing some cap­i­tal up­side po­ten­tial in a fall­ing in­ter­est-rate en­vi­ron­ment


Fi­nance min­is­ter Pravin Gord­han con­tin­ues to be ha­rassed by the Hawks


Kevin Lings says Moody’s sprang a sur­prise

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