Are bonds an opportunity?

COUNTERINTUITIVE: GOING AGAINST THE HERD

Pessimism about the local economy may be at an all-time low, but that may just be the perfect time to buy.

When Nhlanhla Nene was dismissed as finance minister in December 2015, yields on 10-year government bonds blew out to 10.5% at their peak.

Few people saw this as a buying opportunity – South African government paper was seen as too risky.

Rare opportunity

In hindsight, however, it was the best investment opportunity South African investors had seen for some time. Local bonds were the best-performing asset class in 2016, delivering a return of 15.5%.

Following the dismissal of Pravin Gordhan and the ratings downgrade from S&P, it may seem that we are in an environment that is fairly similar. Yields on 10-year bonds have risen nearly one percentage point from mid-March to current levels around 9%.

So, is this buying territory again?

“I think the risk with this kind of environment is you easily get sucked in and miss an opportunity, which is why this is a good question,” says Zain Wilson, analyst at Old Mutual’s MacroSolutions boutique.

The head of fixed interest at Sanlam Investment Management (SIM), Mokgatla Madisha, feels there are some crucial differences. “The market was a lot better prepared this time around,” he says. “We were already priced for a downgrade, which is why the reaction was more muted. “Secondly, commodity prices are very supportive of the rand at the moment,” Madisha adds. Foreigners have been significant net buyers of South African bonds in recent days. Clearly, they believe that the yield-to-risk ratio is disproportionately high. However, Wilson says it is an opportunity that you should approach with your eyes wide open. Analysis done by MacroSolutions suggests that markets act consistently at the point of a downgrade.

What happens after that depends on whether the country suffers multiple downgrades. This means that you have to be very astute in your risk management.

“Our conclusion is that South African bonds offer value at these levels, but the question is not whether or not you should be buying, but how much you should have,” says Wilson.

SIM’s Madisha argues that it’s too early to tell whether bonds present a buying opportunity.

Rand performance

“I think a lot will depend on the rand,” he says.

“If it stays within deflationary territory – in other words, firmer than last year’s average level of R14.40 to the dollar – the outlook for inflation will stay reasonably supportive and you can say bonds offer reasonable value at these levels.

That’s because inflation will be heading towards 5.5% for this year and then the real yield you are getting on bonds is attractive.”

However, if the rand falls beyond that mark, the risk of higher inflation and even higher interest rates come into play.