Taking events in its stride

Foreign investors, in their hunt for yield, have turned aggressively risk-on towards emerging market bonds

Things look grim for SA. It finds itself in a recession, its political landscape is racked with uncertainty and scandal, and its government debt has been downgraded to the brink of full noninvestment-grade junk status.

Bond yields should be racing higher, or so many may have thought. But the bond market has shrugged off a wave of bad news this year with the yield on the key R186 10-year government bond down from a peak of 9% to its current 8.5%.

“It has all left a lot of local bond market players very confused,” says Malcolm Charles, head of fixed income at Investec Asset Management.

Moody’s announced the downgrading of SA’S local and foreign debt ratings from Baa2 to Baa3, its lowest investment grade rating, on June 9. It was the latest piece of bad news to strike.

The ratings agency also assigned SA a negative outlook.

The yield on the R186 took the downgrade in its stride, blipping up only 5 basis points (bps) following the announcement.

Moody’s joined Standard & Poor’s (S&P), which had cut SA’S foreign currency rating to a junk BB+ and its local currency rating to BBB-, its lowest investment-grade rating, on April 3. S&P’S action followed President Jacob Zuma’s axing of Pravin Gordhan as finance minister.

Amid all the bad news many SA investors have been left asking: why is the bond market so resilient?

“You have to look at the bond market through the eyes of foreign buyers,” explains Henk Viljoen, Stanlib’s head of fixed income. “Foreigners are now the dominant players in our bond market.” So dominant that they today own 47.5% of all nominal (noninflation-linked) government bonds, says Leon Krynauw, head of fixed income at Sasfin. The value of foreign investor holdings is about R600bn.

In their hunt for yield, foreign investors have turned aggressively risk-on towards emerging market bonds. It has made net foreign buying of these bonds jump to Us$38bn in the first five months of this year from $250m in the same period last year.

“Inflows into emerging market bonds in the five months to May were higher than in any previous full year,” says Albert Botha, an Ashburton Investments fixed interest fund manager.

SA’S bond market received its fair share, with net foreign buying to the end of May coming in at R48bn. “That’s a lot of money in this market,” says Krynauw.

Foreigners are getting “fantastic yields” on SA bonds, says Viljoen. They range up to 9.5% on the longest-dated bond, the R2048, maturing in 2048. “Foreigners look at real [after-inflation] yields,” says Viljoen. “On the R186 they are getting a real yield of about 3%.”

Compared with developed markets the yield uplift is substantial. For example, the US 10-year government bond’s real yield is a marginal 0.25%, while in countries such as Germany and Japan real 10-year yields are negative.

Barring a major domestic or global upheaval, the outlook for SA bonds for the rest of 2017 appears set fair. The market is also likely to benefit from a cut in the SA Reserve Bank’s repo rate. “I expect [the Bank] to cut the rate by September,” says Charles.

But the SA bond market is far from out of the woods. Reviews by S&P and Fitch loom in early December. S&P has SA on a negative outlook while Fitch, the smallest of the big three rating agencies, downgraded SA’S foreign and local currency ratings to a junk BB+ in April.

S&P has left little doubt that on SA’S current economic and political trajectory its next move will be to downgrade SA’S domestic rating to junk status. SA’S foreign and domestic ratings by Moody’s are equally at risk.

If things do not improve SA will have a fullhouse junk rating by June 2018, warns Viljoen.

“Further downgrades by S&P and Moody’s can be averted,” says Krynauw. “But government will have to act quickly to reform [stateowned enterprises] and engage with labour and the private sector.

“There has to be more certainty.”

Bond investors will have to ask themselves what chance there is of all this happening.

Very slight, it would seem. Inaction is the order of the day. Nothing has yet come of a cabinet decision in August 2016 to set in motion reform of state-owned enterprises, while the national development plan appears all but forgotten.

A derating of SA domestic bonds to junk by S&P and Moody’s would be devastating news. It would remove SA bonds from the domestic investment grade-bond tracking index, Citibank’s World Government Bond Index, which is by far the largest of this form of index. SA bonds have been included since October 2012.

SA’S exclusion from the index would result in many foreign asset managers with investment grade-only mandates dumping SA bonds. Botha and Viljoen estimate total selling at R120bnr150bn. “Yields would spike about 100 bps, assuming emerging markets are still in favour,” says Botha.

Charles believes the damage would be worse. “Yields would spike 150 bps-200 bps,” he says.

It would make the bond market a very unpleasant place to be invested. On a 200 bps rise the capital loss would be 14%, says

Charles.