Financial Mail - Investors Monthly
A licence to thrill?
The SA bond market has the makings of a great investment story despite the risk, writes Stafford Thomas
“On March 23, Moody’s announced it was not downgrading SA’s sovereign credit rating to junk status and had revised its credit outlook to stable from negative
Investors in SA bonds have had reason to smile so far this year. They backed what has been SA’s bestperforming asset class by far.
To mid-April the JSE all bond index romped home to deliver a total return of 7.5%. It comfortably beat the JSE all share index, which registered a 4% decline, and trounced the listed property sector, where prices slumped by 15%.
Investing in a money market fund would have produced a return of about 2%.
For bond market investors it has been a far cry from the situation they were facing as recently as November last year, following the gloom-and-doom medium-term budget policy statement (MTBS) delivered by former finance minister Malusi Gigaba on October 25.
His speech sent a shock wave through the bond market, which reacted by driving the yield on the key R186 10-year government bond from a close of 8.8% the day before to a high of 9.44% just two days later.
It was the R186’s highest yield in two years.
It is important to remember that when bond yields rise bond prices fall and vice versa.
More bad news came on November 24, when Standard & Poor’s announced it had downgraded SA’s sovereign credit rating to noninvestment ( junk) status. Only Moody’s was still affording SA an investment-grade rating, albeit at its lowest level — Baaa3 — with a negative outlook.
A downgrade to junk by Moody’s would have been a huge setback for the bond market. It would have resulted in SA bonds being removed from the domestic investmentgrade bond tracking index and the Citi Bank’s World Government Bond Index, and would have sparked selling estimated at up to R150bn by foreign asset managers with invest- ment grade-only mandates.
The gloom that then permeated SA was reflected in the decline in business confidence to its lowest level since 1985, the year former president PW Botha delivered his economically suicidal Rubicon speech.
Then the tide started turning in SA’s favour. The first big positive came on December 18 with the election of Cyril Ramaphosa as ANC leader.
The bond market’s reaction was immediate: investors pulled the yield on the R186 down to 8.55% by year-end.
The news got even better on February 15, when Ramaphosa was elected as SA’s president following the ousting of former president Jacob Zuma. It attracted more strong buying by foreign and local investors. They hauled the R186 yield down to 8.03% within a week of Ramaphosa’s election.
It was the R186’s lowest yield since May 2015.
March brought more positive news for the bond market. National treasury took it by surprise with an announced on March 20 that it was to reduce the amount of bonds being offered at its weekly auctions.
In the case of a nominal bonds auction, offers have been reduced from R3.3bn to R2.4bn, while for inflation-linked bonds auction offers are down from R900m to R600m. It was a clear signal that government
was determined to live up to its promise of reducing its reliance on debt and improving SA’s fiscal health.
Matters improved further on March 23, when Moody’s announced it was not downgrading SA’s sovereign credit rating to junk status and had revised its credit outlook to stable from negative.
“Moody’s move . . . came as a positive surprise to the market,” says Albert Botha, a fixedincome fund manager at Ashburton Investments.
The development was enough to give the bond market another positive kicker, with the R186 yield falling to a low of 7.83% on March 27.
That appears to have marked the end of the winning streak, at least for now. The R186 yield has since gone on to rebound to about 8.1%. “The Ramaphosa political sentiment honeymoon is over, but it’s no train smash,” says Henk Viljoen, head of fixed income at Stanlib.
The rebound in SA bond yields comes at a time when emerging market (EM) bonds in general are out of favour with foreign investors.
“The standoff between the US and Russia over US military intervention in Syria is not helping sentiment,” says Viljoen. The influence of foreign investors in the SA bond market is significant. “Foreigners own at least half of SA government nominal bonds,” he says.
But despite a more risk-off approach to EM bonds by foreign investors no material damage has been done to EM bond prices.
This is reflected in the largely sideways movement, in a narrow range, in the JP Morgan emerging market government bond index since February.
Another area of potential concern for EM bonds is the trend in US government bond yields, where the focus is on the 10-year bond.
Influenced by the steady tightening of monetary policy by the US Federal Reserve open market committee (OMC) since December 2015, the 10year bond yield has lifted from a low of just over 2% in 2016 to a high of 3.2% in February. It has since eased to just on 3%.
A move in the 10-year yield to much above 3% would be bad news for EM bonds, says Viljoen. But Malcolm Charles, a fixed income fund manager at Investec Asset Management, believes this is unlikely. “The US bond market is well-priced for the current macroeconomic environment,” says Charles. “The market is pricing in another three or four increases in the Federal funds rate.”
The OMC has lifted the Federal funds rate — the equivalent of SA’s repo rate — six times since tightening began from just over 0% to a current target range of 1.5%-1.75%.
Veteran US bond market player Bill Gross of Janus Henderson Investors shares Charles’s view on the outlook for the US 10-year yield.
In his March market review Gross wrote that 10-year treasuries “should fluctuate around 3% for most of 2018. The Fed’s purported three to four [Federal funds rate] hikes this year are likely exaggerated. The US and global economies are too highly leveraged to stand more than a 2% Federal Funds level in a 2% inflationary world. If more than 2%, a stronger dollar would affect emerging market growth and lead to perhaps premature [monetary] tightening on the part of the [European Central bank] and other developed market central banks.”
With the risk of a big jump in US bond yields seemingly low, the big question for SA bond investors is: where are yields headed for the rest of this year? Views are mixed.
“I believe SA bond yields will be stuck in a tight range for the rest of the year,” says Viljoen. “At the R186’s current trading level investors in bond funds can expect to have earned a total return of about 9.25% after costs in 2018.”
Botha has a similar view. “I find it hard to identify further factors that will drive bond yields lower,” he says.
“SA bonds are now also overweight in foreign investor and local investor portfolios. I expect yields to stay flat for the rest of the year.”
Charles’s view on the prospects for bond yields during the rest of 2018 differs radically from those of Viljoen and Botha. “People are impatient,”
“State-owned enterprises are also in for a huge shakeup following Ramaphosa’s appointment of Pravin Gordhan
he says. “I believe the market has just paused after its strong run. There is still a very strong story to be fully played out.”
Charles says people forget that Ramaphosa has been president for a short time and has already made many sweeping changes for the better.
Among these is the appointment of Mark Kingon as acting head of the SA Revenue Service in March following Ramaphosa’s suspension of commissioner Tom Moyane.
State-owned enterprises are also in for a huge shakeup following Ramaphosa’s appointment of the no-nonsense Pravin Gordhan as minister of public enterprises in February.
Charles believes SA bonds are still trading at what he terms a “bad governance premium” when compared with other EM bond yields.
“The premium is between 50 and 100 basis points,” says Charles. “If the premium falls by just 50 basis points the R186 can produce a total return of about 13% this year.”
While the SA bond market has the makings of a great investment story, there are investors who are still not prepared to accept the associated risk. The obvious alternative is a money market fund, where the net yield after fees will be at around 7%.
However, at a marginal extra risk income funds are a strong contender. The funds invest primarily in bank and other corporate paper with yields linked to the Johannesburg interbank average rate.
Viljoen says: “Investors can now expect to earn about 8.25% from an income fund after fees.”
Whatever investment route is followed, — bond funds, money market funds or income funds — SA investors are in the comfortable position of earning a real rate of return well ahead of inflation, which came in at 4% in February.