South African government bonds: cheap now on improving fundamentals
Victor Mphaphuli
Head of Fixed Income
Key takeouts
- SAGBs have not been spared in the global sell-off in government debt so far in 2022.
- The outlook for SA’s debt sustainability has significantly improved over the last year.
- SAGB valuations are compelling against cash now and offer among the highest real yields in the world.
As Dorothy observes to her dog Toto, ‘We aren’t in Kansas any more’. In the end, Dorothy got home again simply by clicking the heels of her ruby slippers. By contrast, bond markets are stuck in a new and uncomfortable reality. That said, we think that South African government bonds offer good value after a big sell-off.
In 2022, the benign rate environment of the last fourteen years fell apart in spectacular fashion. Recession is looming and an entire generation of bond traders and investors are learning a new word: stagflation.
Sovereign bonds are in a generational bear market: global and emerging market indices are down 20% in USD terms year to date and you have lost money on the investment you made in sovereign bonds five years ago.
South African government bonds have not been spared. Like its peers, the South African Reserve Bank (SARB) was caught behind the curve and has been scrambling to reassert its credibility by hiking rates into positive real territory. Despite the current uncertainties and the country’s weak growth outlook, we think that the fundamentals of South African sovereign debt are improving and it now offers value.
The story of 2022: inflation running hot, central bankers running to catch up
When inflation data started to break out earlier this year, central banks remained calm, characterising the increase in prices as transitory. Subsequent events have shredded that assessment: consumer prices have risen faster now than at any time in the last 40 years. Interest rates primarily affect demand in an economy, not supply, and are an inadequate weapon for central banks to suppress the current wave of inflation which is dominated by supply-side factors. Global supply chains were still reeling from the COVID-19 pandemic when Russia’s invasion of Ukraine threw a hand grenade into the energy and food complex.
‘Demand destruction’ is the euphemism of the day. Rising rates mean that ordinary citizens must now foot the bill to get inflation under control. Fed Chair, Jerome Powell, admitted as much when he said in August that businesses and households will have to endure ‘some pain’ while the Fed tames the beast of inflation.
The SARB finds itself in an unenviable position, obliged to hike rates to defend a weak currency despite persistently low growth. The macro environment has certainly been challenging for the rand. The current account posted a surprise deficit in Q2 as the trade surplus narrowed by a quarter and the outflow of dividends and interest payments hit a 60-year record.
It may surprise you that STANLIB is bullish on SA sovereign bonds.
South Africans are notoriously bearish on the country’s prospects (perhaps because load shedding tends to dampen one’s enthusiasm), but our analysis indicates that the nation’s finances and their governance are improving and that SA’s sovereign credit rating will improve from here. If the government can deliver its promised reforms and fiscal consolidation, we believe that SA could return to the club of investment grade nations sooner than expected. It would certainly help if the politicians were to ‘get out of the way’ and prioritise the national interest over narrow factional interests. Our bullish view on South African government debt is based on the following four observations:
1. Inflation has peaked
We think that consumer price inflation is peaking and that the SARB is now hiking to remain in step with central banks in developed economies to defend the rand. It would be naïve to expect the SARB to admit this in public forums, but defending the currency is rational. Weakness in the rand is a major driver of inflation and interest rate differentials are a key lever in the value of the currency.
2. Markets are too hawkish
Central banks in emerging markets have hiked their rates into ‘neutral’ territory (i.e. the real interest rate at which inflation would be stable at full employment) or beyond, and some have indicated a desire to decouple from their peers in developed markets (e.g. Brazil, Chile, Czechia, Poland). The risk that further currency depreciation will add to imported inflation is more of a risk for countries with poor external balances, like Hungary, than it is for SA. SA is also better-positioned by having less hard currency debt than its EM peers.
We therefore believe that fixed income markets are too hawkish on the path of South African interest rates: where they predict another 200 bps of tightening, we e expect no more than 100 bps.
3. SA’s fiscal position is improving
The South African government’s finances are surprising on the upside. Fiscal consolidation is progressing faster than expected and we expect the primary balance (government revenue minus non-interest expenditure) will move into surplus sooner than expected, not least because of Treasury’s increasingly effective gathering of taxes. The following chart shows how the recent Medium-Term Budget Policy Statement offered the third consecutive improvement in the government’s debt trajectory since the February 2021 Budget.
4. Valuations are compelling
We believe that the market is overstating the risk of further hikes and there is good value in the short end and the belly of the SAGB yield curve. We expect more volatility over the short term but we feel we have a clearer view of value through the cycle based in the following:
a. Current valuations give room for error.
The South African All Bond Index (ALBI) is now yielding 11.30% with a Modified Duration of 6.2 years. This means that the yield on the ALBI could rise by another 50 bps over the next 12 months and still deliver a return of 8.5%, equivalent to that offered by a 12-month cash deposit today.
b. South African bonds are cheap relative to other countries
South African government bonds (SAGBs) also look attractive on a real basis. Among major nations, only Brazil is offering a higher 10-year real yield (10-year government bond yield minus current inflation).
After years of underperformance, particularly during the COVID pandemic, SAGBs have been a big outperformer this year. Since the beginning of 2022, global and EM sovereign bonds have returned -19% and -21% respectively, while SAGBs have returned -0.3%.
c. The valuation of SAGBs reflects an excessively bearish view of sovereign credit risk
The following graph decomposes the yield on the benchmark 10-year SAGB into three notional ‘building blocks’. Two of them are observable in markets and the third is the residual:
- the current yield on the world’s reference ‘risk free’ asset (the US 10-year bond)
- the premium that investors are currently demanding for exposure to South African government credit (the current sovereign CDS spread), and
- the premium that investors appear to be demanding for exposure to the two remaining risk factors, the rand and South African inflation.
This article appears in the Q4 2022 edition of our StandPoint publication. Click here to download a copy of the full publication.