Can you bet on South African government bonds now? - Prudential
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A N A LY S I S
iStock 1133579537
Can you bet on South
African government
bonds now?
Roshen Harry
PORTFOLIO MANAGER
i KEY TAKE-AWAYS
The SA bond market is facing the risk to investors is less than many
threat of a downgrade to sub- believe. Our most likely scenario is for
investment grade level by Moody’s, some initial strong selling followed
which would expel our bonds from quickly by buying by investors wanting
the World Government Bond Index the attractive yields on offer. We
and prompt sales by index-trackers believe the yields now on offer are
and investors unable to hold sub- attractive, adequately compensating
investment grade bonds. investors for this risk already.
While there are different views of
Prudential Investment Managers ©
the bond market reaction should this
happen, at Prudential we believe this
is already largely priced into current
bond yields, and that therefore the
Consider this QUARTER 01 2020 Page 1
A N A LY S I S Can you bet on South African government bonds now?
G
oing into 2020, South Africa faces Services (Moody’s) of our sovereign
weak growth, persistent fiscal investment grade rating from Baa3
concerns and a possible ratings to a sub-investment grade rating.
downgrade. In addition, December’s This downgrade would result in the
bouts of power cuts have weighed on automatic expulsion of South African
market and consumer confidence and government bonds from the World
raised the chances of the economy Government Bond Index (WGBI). What
moving into a recession. The Medium- would be the effects of this move?
Term Budget Policy Statement (MTBPS)
delivered in October 2019 forecasts Possible impacts of exclusion
the public debt-to-GDP ratio to reach from WGBI
a worryingly high 71.3% in 2022/23, One view is that this exclusion
with no debt consolidation in sight will cause foreign investors to sell
– news which was not well received between US$3 billion and $10 billion
of our government bonds. With these
by the market. Some assert that the
bonds needing to find a home, bond
MTBPS was used as a tool to signal
yields would, as a result, increase
to government the country’s urgent
meaningfully.
need to embark on its reform agenda,
which would boost much-needed Another view suggests that the WGBI
growth. This, in turn, would increase investor exposure to South African
revenue collections over time and pave bonds is only moderate, and so an
the way for an improvement in public increase in yields from a WGBI exclusion
finances, ultimately reducing the cost would be only temporary, as non-
of capital. Whatever your view, it is benchmarked investors and local fund
clear the fiscal position has added to managers would snap up the bonds as
the basket of risks which have weighed they became attractive. A third view is
on the local bond market, given that that the downgrade to sub-investment
any further fiscal blow-outs would grade could ease market uncertainty,
result in the government having to which could result in the stabilisation
issue more debt. of government bond yields.
Entering the new year against this As is the norm in any well-functioning
backdrop, one factor that will be market, there are clearly a range of
hanging over our government bond differing views on this topic. By and
Prudential Investment Managers ©
market is the increased risk of a large, however, investors appear to be
downgrade by Moody’s Investor generally pessimistic with respect to
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South Africa’s growth prospects and Inflation
fiscal health in the medium term. That When looking at bond yields it is
pessimism, we think, is largely reflected important to consider inflation, given
in the elevated level of government that it erodes the purchasing power of
bond yields in the local market. This the returns investors receive over time.
article will try to provide some reasons The higher a country’s inflation rate is
as to why we at Prudential think South expected to be (inflation expectation),
African (SA) government bonds offer the higher the yield an investor should
value for investors at their current require to compensate for this erosion
yields. of purchasing power. The yield investors
receive after adjusting for inflation is
Prudential’s view on SA government called the “real” yield. Currently, SA
bonds inflation outcomes show subdued
Considering all of the negative factors inflationary pressures, much like most
above, our view is that much of the of the developed world, at 4% y/y in
prevailing pessimistic sentiment is December 2019, well below the South
already priced into government bonds, African Reserve Bank’s mid-point
and therefore any potential bond inflation target of 4.5%. Meanwhile,
market sell-off will not be as severe according to the Bureau for Economic
as many anticipate – after all, markets Research (BER)’s fourth quarter 2019
are forward looking. Consequently, survey, expectations for headline
we consider these assets to be cheaply inflation are trending downwards
valued, offering attractive returns in towards the SARB’s mid-point target,
the medium term (over three to five now at 4.5% for 2019 (from 4.6%
years). Below I discuss inflation as an in the previous quarter). Inflation
important factor, as well as three key expectations for 2020 and 2021 have
measures which support our view continued to ease gradually and are
(historic real bond yields, relative credit at 4.8% and 5.0%, respectively, the
default swap spreads and relative real lowest levels since 2007, and five-year-
bond yields), keeping in mind that ahead inflation expectations have
this is not an exhaustive list. These also declined to 4.9% from 5.0%. Two
measures do, however, form part years ago the latter was closer to 6%,
of our investment decision-making at the upper end of the SARB’s 3-6%
Prudential Investment Managers ©
process. inflation band.
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High real bond yields Graph 1 (in the left box) plots the yield-
Looking at absolute yield levels as of 16 to-maturity of our 20-year government
January 2020, long-dated government bonds since the year 2000 alongside
bonds as measured by the 10- and SA’s expected annual inflation rate.
20-year bonds are yielding about The right box illustrates real yield,
9.0% and 10.10% respectively, at which is the difference between the
the upper end of their trading range bond yield and SA inflation. They
over the past four years. SA’s subdued clearly highlight that real yields are
inflation gives investors who buy at elevated levels compared to the
long-dated bonds the ability to earn observation period. They are also well
attractive real yields of about 4.5% above our view of their long-run fair
to 5.6% in the 10- to 20-year tenors, value (which is around 2.5%). Hence
assuming inflation is anchored at 4.5% this supports our conviction that
over the term of the bonds. Using long-dated government bonds offer
the Bloomberg consensus headline attractive returns over the medium
inflation forecasts for 2020 and 2021 term.
of 4.7 and 4.8% respectively, inflation
is expected to be well behaved in Elevated relative credit default
the near term. Alternatively, using swap spreads
BER’s five-year inflation survey, the Another way to measure how the
longer- term inflation outlook has also market is valuing South African debt
moderated. Remember that investors is to compare the country’s credit
are still assuming inflation risk, in default swap (CDS) spread versus other
believing that the SARB will continue countries. A CDS can be thought of as
to exercise its mandate successfully an insurance policy that can be bought
and not lose its credibility by letting against a default or other credit event
inflation run back to the upper end of by the debtor. They are essentially
its inflation target band and beyond. derivative contracts that transfer credit
Should inflation return to the 6% exposure between counterparties.
level, the real return on long-dated The higher a country’s credit rating,
bonds would fall to 3% to 4%, but we the lower the CDS spread (since there
would still consider to be an attractive is less risk involved in holding their
Prudential Investment Managers ©
return proposition. debt) and vice versa.
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Graph 1: Attractive real bond returns on offer
Nominal 20yr bond yield vs inflation Real 20yr bond yield rises
16 8
7
14
6
12
5
10
4
8 3
2
6
1
4
0
2
-1
0 -2
Oct Oct Oct Oct Oct Oct Oct Oct Oct Oct Oct Oct Oct Oct Oct Oct Oct Oct Oct Oct
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
SA 20 Year Bond SA Expected Inflation Real Yield
SOURCE: IRESS, Bloomberg 31 December 2019
Graph 2: SA already priced at sub-investment grade by market
Five-year credit default swap spreads
600
Kuwait
Iraq Mexico Chile Hong Kong
500
Cameroon Saudi Arabia China South Korea
United Kingdom
Angola Uruguay Lithuania New Zealand
Tunisia Colombia Ireland
400 Latvia
Pakistan Japan Finland
Hungary
5y USD CDS spread
France
Ukraine Peru Austria
Kenya Russia Israel
Nigeria
300 Costa Rica Spain Canada
El Salvador Rwanda Indonesia
Egypt Turkey Malaysia Slovakia
Bulgaria
Senegal Oman Panama Australia
200 Iceland Qatar
South Africa
Bahrain Guatemala Portugal Slovenia Estonia Germany
Italy
Greece Cyprus Czech United States
Panama
100 Brazil Morocco Netherlands
Serbia India Norway
Croatia Romania Poland Czech Denmark
Kazakhstan Thailand Belguim Switzerland
0
B- B B+ BB- BB BB+ BBB- BBB BBB+ A- A A+ AA- AA AA+ AAA
Prudential Investment Managers ©
Local currency rating: Median of 3 agencies
SOURCE: S&P, Fitch, Moody’s, Bloomberg 16 January 2019
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Graph 2 shows the five-year CDS spreads “Equally, countries rated in
of investment and sub-investment the lower range of investment
grade countries, with the latter plotted grade (BBB-) are trading at CDS
in the shaded area. South Africa’s CDS spreads of 75 to 125 basis points
spreads are already trading at about (0.75% to 1.25%), lower than
170 basis points (1.7%, as shown by South Africa.”
the red dot), comparable to countries
that have sub-investment grade ratings economic growth outlook worsen even
of BB. Equally, countries rated in the more. This could then cause a shift in
lower range of investment grade (BBB-) market expectations toward further
are trading at CDS spreads of 75 to downgrades to come, and more bond
125 basis points (0.75% to 1.25%), market weakness as the government
lower than South Africa. This clearly would be forced to borrow more.
shows the market is already pricing Hence the urgent requirement for fiscal
South African debt at sub-investment responsibility and growth-enhancing
grade. reforms.
Based on this observation, we could High relative real bond yields
infer that should Moody’s downgrade Finally, Graph 3 compares 10-year
SA to sub-investment grade, the odds real bond yields across some of South
of further extended weakness in our Africa’s peer countries, where our
government bond market are rather government bonds undeniably stand
slim. There could be initial knee- out as offering very attractive real
jerk selling following the news of a yields. Using the S&P long-term local
downgrade, but we believe this could currency rating, SA has a higher credit
evaporate rather quickly as investors rating than both Brazil and Turkey,
see a good buying opportunity. and can offer highly developed, deep
and liquid financial markets along with
Of course this scenario bars any further strong macroeconomic institutions that
deterioration in the national fiscus are viewed as credible by international
that might occur this year, should institutions; yet it offers higher real
projected debt levels continue to rise yields to investors. Equally, the graph
Prudential Investment Managers ©
more sharply than expected or the shows the unattractive (negative)
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Graph 3: SA real bond yields higher than most countries’
10-year real yields
4.5%
BB+
4.0%
3.5%
A- BB-
3.0%
2.5% BBB
2.0%
Real Yield
BB-u
BBB-u
1.5%
1.0%
0.5%
0.0%
-0.5% AA+u
-1.0%
United States Mexico India Indonesia South Africa Brazil Turkey
SOURCE: Bloomberg, Consensus Economics 20 January 2020
real yield on 10-year US Treasuries, we find that bargains are to be had in
indicating their poor return prospects. financial markets when the news flow
Real returns are even more negative is positive and market confidence is
on most European government bonds. high. In a Bank of America Securities
Although SA’s long-dated bonds could SA Fund Manager review, the majority
weaken further, if an investor is willing of fund managers considered the
to ride out the volatility over the South African 10- year government
medium term, prospective returns
bond to be undervalued, and more
are very likely to be attractive given
managers were bullish on SA bonds
the starting yield.
on a 12-month view than bearish. Yet
Overweight SA government bonds only 25% would buy them at current
In this article I have highlighted some levels and the vast majority would
of the primary risks associated with our only be buyers at cheaper levels. This
government bonds that could cause indicates excessive pessimism toward
Prudential Investment Managers ©
investors to avoid them. Yet rarely do our assets. Yet even though these assets
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can become cheaper, we do not have including the Prudential Balanced
much faith in the ability of investors Fund, Prudential Inflation Plus Fund
(including ourselves) to successfully and Prudential Enhanced Income Fund.
time the markets consistently – in We find that, although these assets
this case, to time the bottom of the do certainly face some challenges in
market. Hence, for valuation-based the coming year – including a possible
investors like ourselves we consider credit rating downgrade – their current
the investment proposition to be an real yields adequately compensate
attractive one. investors for assuming the risks of
owning them.
Investing is not a sure thing, and no
position is without risk; this is why
we at Prudential have a risk-based
approach to investing. Our approach
is to scale into positions over time,
gradually building our exposure as
assets become cheaper. Currently we
are constructive on long-dated SA
government bonds in our portfolios,
with the capacity to invest further
capital into these assets should yields
rise even further.
At the start of 2020 we are overweight
longer-dated South African government
bonds in our multi-asset unit trusts,
Roshen joined Prudential in 2006 and is the joint-Portfolio Manager of several Prudential funds.
With 19 years’ industry experience, Roshen completed his articles at Deloitte & Touche before
joining Rand Merchant Bank in their Risk and Compliance division. He holds a Bachelor of
Commerce degree and a Post Graduate Diploma in Accounting, both from Rhodes University. He is
Prudential Investment Managers ©
a qualified CA (SA) as well as a CFA charterholder.
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