Financial Mail - Investors Monthly
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
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