This is a summary of an article by Portfolio Manager, Peter van der Ross. We would highly recommend reading the full article on STANLIB.com, by clicking here.

In February 2020, we assessed nominal South African Government Bonds (SAGBs) through our six-lens Tactical Asset Allocation framework. We concluded that, although SAGBs appeared cheap, there were significant and growing risks.

Since then, the single biggest event was 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.

The global debt funding environment is favourable for issuers

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  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.

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 to achieve their required return outcomes.

Developed market bonds vs SAGBs

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.

10-year SAGBs began the crisis at around 9%, sold off to 12.3% on 23 March, looked to settle post-crisis at around 9.5%, and, during the sharp vaccine-driven risk-on of November, rallied back to 9%.

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.

Our comparison of sovereign credit default swap (CDS) spreads, which provide a comparison of relative default risk, suggests that SA’s sovereign default risk is broadly correctly priced. If we combine that with SA’s 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.

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. However, 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.

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.

Since May, National Treasury’s weekly gross issuance has averaged R12 billion, yet yields have stabilised and even rallied. 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 expect that there will be opportunistic switch auctions to ease the burden of the R2023 maturity well in advance of that time.

We remain firmly of the view that SA’s fiscal trajectory makes default or some form 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.

Strong momentum and risk-adjusted returns

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, 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.