Carnage looms for SA bonds

On one level, it seems they are priced attractively. But with a downgrade looming, that’s a big risk . . .

It didn’t make the headlines, but if you want a sense of just how awful finance minister Malusi Gigaba’s medium-term budget policy statement (MTBPS) was, the carnage in the bond market is a good indicator.

Within hours of Gigaba’s budget, bond yields soared to their highest levels in almost two years. “The MTBPS was a brutally honest assessment of where SA is,” says Leon Krynauw, head of fixed income at Sasfin Securities.

With economic growth almost at a standstill and tax revenue expected to fall R51bn short of projections, things look horrid.

For the bond market, the worst news to come out of the MTBPS was that government’s net debt to GDP will breach 60% in the next two years, once guarantees to state enterprises are added in. This is way above the 52% forecast in the February budget, and it will leave government debt at a staggering R3 trillion by 2020.

The reaction was so aggressive that it drove the key R186 10-year government bond’s yield from a close of 8.8% the day before to a high of 9.44% two days later. The longest-dated bond, the 31-year R2048 jumped from 9.8% to 10.4%

“The market stabilised after the sell-off,” says Henk Viljoen, head of fixed income at Stanlib. It has left the R186 trading at about 9.1%.

But the risk of another sell-off that could push the R186 well above 9.44% remains high.

The sword of Damocles hanging over the market is the risk that rating agencies S&P and Moody’s will downgrade SA’S domestic credit rating to junk. Now on the brink, SA’S rating is a mere one notch above junk status.

The other danger for SA’S bond market is that foreigners own R660bn worth of government bonds — about 40% of the amount in issue, says Krynauw. How they react to Gigaba’s budget is perhaps the most critical factor now.

“The first worry is that foreigners stop buying [bonds],” says Viljoen. “If they do, it will put more pressure on the local market.”

In the first nine months of the year foreigners made net bond purchases of R17.1bn. But on the day Gigaba spoke, they dumped R5.8bn in government bonds. “It could have been some fast-money selling,” says Viljoen. “We must wait a few weeks to see what serious investors do.”

However, if SA is junked, it would mean SA bonds are removed from the Citi world government bond index (WGBI), a tracking index. SA’S exclusion could be devastating: it would lead to foreign asset managers with investment grade-only mandates dumping SA bonds. Estimates of selling range up to R150bn — nearly 10% of the government bonds in issue.

What holds up sentiment, however, is the view that bonds are already cheap, which could ultimately prompt further buying by foreigners.

“SA bond yields are now 200 basis points [bps] above those of [the country’s] emergingmarket peers,” says Malcolm Charles, a fixed income fund manager at Investec Asset Management. “The gap is now wider than it was after the 210 bps sell-off that followed the firing of finance minister Nhlanhla Nene in 2015.”

Albert Botha, a fixed income fund manager at Ashburton Investments, believes a WGBI exit could send the R186 flying to 10%. But he puts forward a strong case for bonds, even at current levels. “The negative sentiment towards bonds feels as if it has been overdone,” says Botha. “Real yields are too high.”

If inflation averages about 5.5% in 2018, the R186’s real (after inflation) yield would be 3.7% and the R2048’s well over 4%. The SA Reserve Bank expects inflation to come in at 4.9%.

On this metric, bonds may look alluring — but the risk of another big sell-off is too real to ignore. It makes money market funds, which are yielding about 8%, safer alternatives.

Better still, and at marginal extra risk, are income funds. “The yield on our income fund before costs is 9%,” says Viljoen.