Updating tactical views on SA Government Bonds – full article
In February 2020, we assessed nominal South African Government Bonds (SAGBs) through our six-lens Tactical Asset Allocation (TAA) framework. We concluded that, although SAGBs appeared cheap, there were significant and growing risks inherent in the asset class.
Our TAA time horizon is 12 months and those six lenses are: valuation, economics, liquidity, momentum, volatility and sentiment.
At the time, the benchmark 10-year point on the curve was trading around 9% and we felt that SAGBs had already discounted a higher probability of default, either explicitly or in higher longer-term inflation outcomes. In real time, however, it is impossible to know with precision how much bad news is priced in, which is why successful fund management is a combination of art and science. In February, we decided that it was time to moderate our material overweight to the asset class (we had been positively predisposed towards it since early- to mid-2016) and move towards a more neutral stance in client portfolios.
Clearly, the single-biggest development since then has been the COVID-19 pandemic, and importantly, fiscal and monetary policy responses. The pandemic has changed the landscape for debt capital markets, as massive fiscal deficits and ballooning debt-to-GDP ratios have become the norm rather than the exception.
The global debt funding environment is favourable for issuers
We periodically look back through history for precedents or periods when there were similar levels of global indebtedness (to get a sense of what happened next) and observe the most recent examples from the developed world occurring at the end of World War II. At that time, it was politically acceptable to borrow aggressively, as debts were built up to finance the war effort. Many global politicians then used military-type language to evoke a similar emotive response from the general populace.
Once again, it has become acceptable to borrow, war-style, as we have been at war with the pandemic, or so politicians would have us believe. To be fair to leaders, they have been faced with a truly awful “lives versus livelihoods” policy dilemma. However, the economic cost of the policy decision to favour saving lives meant “now is not the time to worry about the debt” became the oft-repeated message across developed economies.
Figure 1. No zero-bound for bond yields
Markets have not worried about debt levels in developed economies which benefit from strong, established central banks keeping short rates low or negative.
The US Federal Reserve (Fed), European Central Bank (ECB), Bank of Japan (BoJ), Bank of England (BoE) and Reserve Bank of Australia (RBA) have all acted so boldly that – importantly – markets seem to believe that they have sustainably anchored short- and long-term borrowing costs for both sovereigns and high-grade corporates in their jurisdictions. Aggressive asset purchases from central banks continue to push an increasing quantum of debt into negative-yielding territory – see figure 1.
A favourable environment for borrowers, or issuers of debt, is a tricky environment for investors, who are forced either to embrace more risk in traditional listed asset classes or embrace different risks in non-traditional assets – whether screen-traded or not – to achieve their required return outcomes. By early December, the negative opportunity cost from developed economies’ debt capital markets, combined with the early stages of a recovery in global equity earnings, once again provided strong impetus for a global search for yield, or the carry trade. All other things being equal, SAGBs should be a major beneficiary of this global backdrop.
The scale of monetary and fiscal stimulus from March of this year cannot be underestimated. Policymakers, alive to the lessons learnt in the 2008 Global Financial Crisis (GFC), acted quickly, decisively and in significant volume, arresting the fastest 30% decline ever seen in the S&P500 through the sheer brute force of the weight of money thrown at the problem.
Figure 2 shows the resulting collapse of a handful of developed economies’ bond yields. Initially, the big mover was US Treasury Bonds (USTs), as yields collapsed from 1.58% on 20 February to 0.31% on 09 March. Although UST yields have subsequently settled at c.0.9%, the yields of heavily-indebted nations such as Italy and Greece have traded lower than USTs.
This is another stark example of the distortions that characterise global bond markets, and it is a strong indication that markets are not fighting policymakers. One wonders if the days of the bond market vigilantes are gone, as it is dangerous to fight buyers of assets that have (apparently) no limit to the depth of their pockets.
Figure 2. Greece and Italy can borrow more cheaply than the US
Careful observation of figure 2 reveals two other interesting dynamics.
First, the yields of the more marginal European nations increased in March, before declining as policy interventions have (so far) staved off a credit crisis. In the initial market panic, there was some distinction between safe-haven bonds and riskier ones.
Second, German Bund yields barely moved at all throughout the crisis, highlighting the problem that negative yields destroy the diversification attributes of traditional safe-haven assets. Negative-yielding havens may not lose money during equity market corrections, but they will battle to offset equity losses, so in a portfolio context they are more likely to dampen, rather than diversify, equity risk.
10-year SAGBs also sold off in March, although much more aggressively than government bonds in Italy and Greece, before subsequently recovering some ground – see figure 3.
10-year SAGBs began the crisis at around 9%, sold off to 12.3% on 23 March (figure 3 shows weekly as opposed to daily yields), looked to settle post-crisis at around 9.5%, and, during the sharp vaccine-driven risk-on of November, rallied back to 9%.
Figure 3. UST yields follow short rates lower, but not so SAGBs
However, the 20-year point on the SAGB curve has not recovered to pre-COVID-19 levels as the market has priced in heightened long-term default risk. Figure 3 highlights the stark difference between the Fed’s ability to anchor long-term rates off a lower Fed Funds rate, and long-term SAGBs essentially looking through the South African Reserve Bank’s (SARB) repo rate cuts, and voting that at some future time short rates will have to go much higher.
SAGBs remain cheap
In February, we thought that a sovereign downgrade was imminent, and that despite SAGBs appearing cheap, the downgrade event itself would be painful for bondholders. We could not have known that these events were only weeks away.
In the middle of the March/April market panic, SA’s long term sovereign credit rating was downgraded and in November it was downgraded again, to two to three notches below investment grade.
Fitch and Moody’s have SA’s local currency long-term ratings in line with their foreign currency ratings, whereas S&P has rated local debt two notches below investment grade, and foreign (dollar-denominated) debt three notches below.
Figure 4 shows the evolution of SA’s foreign currency rating in the bars, and in the black line (read off an inverted right-hand axis) we observe the difference or spread between 10-year rand-denominated SAGBs and 10-year dollar-denominated USTs.
Figure 4. SAGB spread to USTs reflecting lower credit rating
From the relatively simple chart above, it appears that 10-year SAGB spreads are roughly appropriate for the current sovereign rating. We ignore the 1998 spike to a 12% spread, as that would have occurred in the immediate aftermath of the Asian crisis. Also, in the late 1990s SA’s CPI inflation ranged between six and eight percent, so our current lower inflation would tend to pull SAGB yields relatively lower now. In spread terms, that would translate to a slightly narrower spread to USTs now than in the late 1990s.
A cleaner way of assessing this spread would be to observe the spread of SA Eurobonds over USTs. Since both assets are priced in dollars, the SA-US inflation differential (or the fact that SA’s inflation rate has moderated over time) is removed as a variable spread component.
The SA Eurobond less UST spread should represent SA’s pure default risk premium earned by the investor who is willing to accept that risk. Now, that risk itself is tradable in the form of a credit default swap (CDS).
CDS spreads therefore represent country default risk relative to US sovereign risk, but CDS are issued by banks, so embedded in them is the default risk (which is very low – remember “too big to fail”?) of the major global banks. Nevertheless, this additional bank risk premium is consistent across the CDS of most sovereigns, so the differential between sovereign CDS spreads is an “apples to apples” comparison of relative default risk.
Figure 5. SA CDS spreads at the wider end of EM peers
Unsurprisingly, SA trades closest to Brazil, as there are many similarities between the two nations: sluggish growth, soaring debt-to-GDP ratios, debts mostly issued in local currency and identical ratings by credit ratings agencies. There is broad acceptance amongst market analysts that both countries’ fiscal trajectories are unsustainable.
There are of course many differences. A material difference is that Brazil has borrowed heavily using short-dated instruments – taking advantage of record low short rates – and in the process has put itself under enormous pressure to continue rolling over that debt. We saw a similar dynamic in SA this year as National Treasury (NT) made extensive use of Treasury Bills, but not nearly to the same extent as the Brazilians. In contrast, SA’s debt maturity profile is reasonably well spread, with the result that SA’s short-term debt ratings are slightly better than its long-term ratings.
Figure 6. SA sovereign debt maturity profile – no imminent refinancing stress
SA sovereign default risk therefore appears broadly correctly priced. If we combine that with low current levels of inflation and the expectation that inflation will stay comfortably within the SARB’s target range over the tactical horizon, this all adds up to SAGB real yields appearing very attractive on a global basis.
Figure 7. SAGB Real Yields look attractive
The notion of a value trap is a bit different for bonds and equities. For a stock, it would not be enough to conclude that it is cheap, and therefore an attractive return could be made from buying it – some cheap stocks are value traps.
For a cheap bond, as long as yields stay roughly where they are, the investor’s return will approximate the bond’s yield to maturity. In the case of SAGBs, that is a very attractive real return prospect. We need to watch carefully for the risk of yields selling off further, but the current global environment will put pressure on yields to compress. If yield compression transpires, SAGBs would deliver outsize returns, but stable yields are sufficient for a credible investment case.
National Treasury remains able to fund itself
The direction of yields will ultimately be a function of supply and demand. In the COVID-19 crisis, National Treasury dramatically increased supply at its weekly auctions at the same time that the sovereign was downgraded, and foreigners stepped away from SAGBs. However, after the initial sell-off, demand returned quickly and most auctions since April have been well supported.
Because of relatively consistently demand, the market barely blinked at the November downgrades. Those downgrades coincided with a strong global risk-on phase, but when markets send us a clear signal, we listen. The signal in this case was that when bad news broke, the asset price did not react negatively – in fact, it barely reacted at all.
Figure 8. Weekly SAGB issuance and Tuesday auction bid-to-cover ratios
As figure 8 shows, weekly gross issuance has averaged R12 billion since May. Because of the nature of the relationship between the major local banks and National Treasury, bid-to-cover ratios should not be problematic. What is more telling is that yields have stabilised and even rallied during this period of heightened issuance. In fact, market appetite has been so good that National Treasury has essentially pre-funded for the remainder of this fiscal year, i.e. to February 2021.
We have already seen that the quantum of maturities for 2021 and 2022 are not onerous and we expect that there will be opportunistic switch auctions to ease the burden of the R2023 maturity well in advance of that time. This year has seen very competent debt management on the part of National Treasury, shown by:
- Changing some technicalities around (weekly Thursday) non-competitive auction optionality to encourage further weekly take-up of stock. Non-competitive issuance has been a key driver of this year’s pre-funding.
- No Eurobond issuance, no doubt recognising the stress global markets were under during the middle two quarters of the year.
- Reasonably heavy issuance of Treasury Bills to capitalise on low short rates, but Treasury has not overdone this issuance and created a refinancing problem, as Brazil has.
- The recent cancellation of switch auctions, easing pressure on the yield curve.
- Tapping the IMF for $4.3 billion of COVID-19 relief funding. Before the pandemic, IMF funding would have been very difficult to achieve politically, as the Ramaphosa camp would probably have been accused of kowtowing to “White Monopoly Capital”.
We remain firmly of the view that SA’s fiscal trajectory makes default or some sort of debt restructuring inevitable. However, the events of 2020 strongly suggest that point is well beyond our 12-month tactical horizon. National Treasury is very much alive and responsive to market conditions, and, for the time being, those conditions support exposing portfolios to SAGB risk. As ever, we hold these opinions lightly, and expect our views will evolve continuously with incoming data.
Strong Momentum and Risk-Adjusted Returns
Since 1960, the average three month-10-year term premium is c.1.5%. However, with our yield curve being one of the steepest in the world, excess returns of bonds over cash have been above average for most of the last five years. The lowest points on a rolling 12-month basis in recent times were this year’s COVID-19-induced panic, when the All Bond Index (ALBI) annual return was 3.7% less than cash, and the surprise firing of Finance Minister Nene, which drove annual ALBI returns 10% below cash.
Given the steep curve and attractive running yield, rolling 12-month returns relative to cash have already recovered from the March rout.
Figure 9. Rolling 12-month excess returns
As the duration of the ALBI has tended to increase over the years, it is no surprise that ALBI volatility has (with some noise), trended up as well. However, this has been very gradual. The Sharpe ratio remains a useful, intuitive barometer for whether an asset adequately compensates an investor for its inherent risks. See figure 10 for rolling three-year ALBI volatility and Sharpe ratios.
Unlike the spikes in rolling three-year volatility in 2008 and 2015, after which Sharpe ratios stayed negative or around zero for a few years, this time the Sharpe ratio has rebounded to positive territory quickly. Again, this is a function of an exceptionally steep curve that is reasonably stable at the long end.
Figure 10. Increasing volatility but with returns to match
Although we apply six different lenses to arrive at our tactical views, these are not always equally weighted. A key part of tactical positioning requires being alive to the factors or themes that markets deem important at a particular time.
As style-agnostic investors, we have the luxury of being able to shift the emphasis we place on different tactical lenses to keep our outputs in tune with markets. This should lead to more consistent performance relative to style-biased investors, whose fortunes tend to wax and wane, depending when market conditions reward their chosen style. Note the key distinction: we invest according to what we think markets will reward, rather than what we think markets should reward.
As a result of the COVID-19 pandemic, sovereign debt levels globally have spiked, making SA’s fiscal position less of an outlier than it was in February. There are certainly material and well-founded concerns over the South African government’s ability to rein in spending and sustainably grow the economy out of its debt burden, which is why SAGB real yields trade at such elevated levels relative to global peers.
Crucially, though, bond yields are paper thin in developed markets, so if bond investors are going to invest in heavily-indebted sovereigns anyway, they will prefer to earn a bit more yield in the process.
Put differently, buying low- or negative-yielding developed markets’ paper adds increasingly asymmetric risk to a portfolio, so high-yielding sovereign paper like SAGBs offers a more attractive risk-return prospect, on a tactical basis. This dynamic enhances and extends the South African government’s ability to fund itself, pushing the looming fiscal crisis further into the future than we had previously thought. Risk-reward still favours being positioned in SAGBs.