SAGBs are priced for stormy waters but Minister Godongwana has a strong hand on the tiller
Victor Mphaphuli
Head of Fixed Income
Key takeouts
We believe South African Government Bonds (SAGBs) offer compelling value at present, despite short-term headwinds. They are currently delivering a real yield of over 5% and National Treasury has demonstrated its commitment to fiscal discipline.
Wage hikes for SA’s public servants will be offset by job cuts, while bail-outs for SOEs come with conditions that will impose longer-term discipline.
- A significant tightening of bank lending standards is likely to follow the US banking crisis, leading to global recession which will harm other emerging market commodity exporters. However, this risk is already priced into SAGBs.
The rand is now massively undervalued.
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After recent weakness, reflecting intensified load shedding and geopolitical tensions, the long end of the South African Government Bonds (SAGB) curve is now yielding over 12%, which means real yields are over 5%. These valuations are in ‘compelling’ territory for us and should be on the radar of tactical asset allocators. This is not to say that the next few months will be plain sailing, but taking a 12-month view, we are convinced that bonds will once again prove to be a valuable diversifier in multi-asset portfolios.
In the previous edition of STANDPOINT, we identified fiscal consolidation as an important component in determining fair value on SAGBs, given the plethora of challenges the government faced over recent years. What cannot be argued away is that the outlook for government’s finances has improved dramatically since the dark days of the Covid-19 pandemic, when some market commentators were projecting that debt levels would approach 100% of GDP (which the market priced in). We can infer from the recent credit default swap market that traders have taken a dimmer view of SA’s creditworthiness over the last few weeks but today we think that SA’s sovereign credit story remains underappreciated. Given the country’s macro challenges, we do not rule out some fiscal slippage over the coming months, but we think that the ‘meltdown scenario’ of fiscal collapse is wildly unlikely.
Trouble for the banks
The US banking sector has been rocked by multiple fallouts, triggered by the secondary effects of higher interest rates. The Federal Reserve’s steepest hiking cycle in living memory has simultaneously raised the banks’ cost of funds, slashed the value of their bond portfolios and sowed fear among depositors. The Federal Deposit Insurance Corporation (FDIC) officially insures deposits up to $250 000, and stepped up to guarantee all of Silicon Valley Bank’s deposits, but risk-averse depositors are still moving their money to bigger banks that are more likely to be seen by the Fed as systemically important. This funding instability could not have come at a worse time for the smaller regional banks that are heavily exposed to commercial real estate, since $270 billion of commercial mortgages will need to be refinanced this year at much higher rates and lower loan to value ratio (LTV)s.
A bank’s risk appetite is unlikely to survive this confluence of events. A significant tightening of financial conditions is at hand which ordinarily should hasten the recession, although tighter labour markets have much to do with the delayed response. Outside of labour markets, all other indicators are pointing to a downward trend.
The US and other DM yield curves remain deeply inverted thereby calling for a recession.
Many emerging market (EM) economies are commodity exporters, so the prospect of a global recession casts a long shadow across the market’s view of their export revenues, current account balances and the valuation of their sovereign debt. EM yield curves have steepened accordingly. However, we think that SAGBs are fully priced for idiosyncratic risk while giving National Treasury no credit for its increasingly assured performance. In the last twelve months the 10-year SAGB has sold off, SA’s yield curve is the steepest among EMs and SA’s credit default swap (CDS) spread has widened more than any other EM country of comparable stature.
We are braced for heightened volatility in the next two quarters as central banks continue reacting to the data, but we still think this is a great starting point for bonds within a tactical asset allocation framework.
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In the coming recession we expect bonds will deliver outsized returns for fixed income investors and strong diversification benefits for equity-centric multi-asset portfolios.
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SA’s growing fiscal sustainability
Our optimistic view of the South African government’s finances is largely based on the discipline being demonstrated by National Treasury. We think despite a very challenging environment, some of which is out of
their control, their intentions of meeting fiscal sustainability still hold. The current National Treasury team has clawed back much of the credibility lost during state capture. We think that SAGB valuations today reflect an excessively gloomy view of SA’s fiscal trajectory, and offer value over the typical horizon for tactical asset allocation.
Almost two years in the job, we think that SA’s Minister of Finance, Enoch Godongwana, has established his credentials by juggling competing priorities within a sensible framework. Markets have relatively low expectations of fiscal discipline in EMs, particularly when an election is on the horizon. So when South African government revenues were boosted by a R45 billion commodity windfall in 2021 and 2022, with the 2024 general election within sight, it was widely expected that National Treasury would open its purse strings.
As it was, the Minister held his ground, presumably spending personal political capital to do so, and reducing bond issuance instead. However, his good intentions are often challenged by other areas of government, which leads to a deterioration of confidence for the country.
It is better to have the Minister in an environment like this, rather than one that can easily be swayed by political populist postulations meant to appease the voters. Countries where rhetoric is too loose usually suffer the consequences when capital leaves the country with no prospect of returning, e.g., Turkey and Argentina.
As he explained in his Medium-Term Budget Statement in October 2022, the country’s debt burden has increased sevenfold since 2008, but on an annual basis the government’s operating cashflow is about to ‘break even’. He said, ‘Yet by the end of 2023/24, revenue will exceed non-interest spending for the first time in 15 years. Net government debt will stabilize at 69 percent of GDP in 2024/25.’
This ‘primary surplus’ projection has come sooner than many expected but it may have to weather domestic challenges, including the impact of load shedding on GDP. Recently National Treasury narrowed the projected primary surplus to a waferthin 0.02% (and more revisions may still come if the economy sheds more growth) but the Minister’s intentions are clear: he understands the profound consequences of losing the confidence of the markets and is prepared to make the necessary choices now to maintain it.
The short-term risks introduced by these challenges are still enormous as the currency and bond markets have reflected despite other EMs faring better. This year, the rand has underperformed EM currencies by a big margin because of local issues. The aftermath of the geo-political risks globally also led to a response from SA that led the global community’s confidence dwindling, evidenced by foreigners selling our bonds and the currency weakening substantially. SA’s response to the Russia/International Criminal Court issue, the threat of sanctions etc., has been quite negative and isolated the country in repricing these risks. Most of this is already reflected in the price of bonds.
In late February, the 2023 National Budget took a positive direction. STANLIB’s Chief Economist, Kevin Lings, described it as a sensible Budget which ‘read the room’. The Minister of Finance recognised that households are under pressure and made good on his promise to support Eskom while demonstrating a level of fiscal discipline that bond investors and ratings agencies will appreciate.
STANLIB’s Fixed Income team agrees with Kevin’s positive analysis of the Budget and are similarly encouraged by the desire to achieve primary balances over the next few years, although current challenges are throwing cold water on this. To achieve these primary balances, it is imperative that reforms that can lead to mitigating the challenges on growth, continue.
Public sector wages
The wage bill remains a bone of contention in the objective to achieve credible fiscal consolidation. Given the dramatic increase in South Africans’ cost of living and the obvious opportunity that creates for the unions to prove their worth, we always suspected that the public sector wage hike would exceed the 3.3% that the Minister put in the Budget. The 7.5% hike that he declared may increase the Budget deficit a little but it came as no surprise. We think it is affordable and has been priced into SAGBs, although we accept that it did not improve the picture for the ratings agencies. Confirming his commendable appetite for unpopular decisions, the Minister made it clear that public sector job losses are coming and that the wage increase will partly be funded by spending cuts in various
departments.
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The steepness of SA’s yield curve demonstrates that the market is not willing to give the Finance Minister credit yet, but that creates an opportunity for the bond bulls.
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No more free lunches: Eskom and the SOEs
The announcement in the February Budget that National Treasury would assume R254 billion of Eskom’s debts over the next three years was not a complete surprise. However, at first glance it still appeared to confirm the widespread belief that the SOEs are irredeemably incompetent, and government lacks the will to hold them to account.
This perception ignores the fact that this debt relief comes with conditions which not only impose fiscal discipline on Eskom but also expose the organisation to independent scrutiny, while preparing the ground for increasing private sector involvement in SA’s energy infrastructure. Seen in this light, despite the current optics of load shedding, time may prove that this bail-out was actually good value for money for the people of SA.
First of all, Eskom must submit to an independent review of its coal-fired capacity by an international consultant appointed by National Treasury. Then Eskom must implement the operational recommendations of that review. The consultants will also determine whether any of the existing power stations can be ‘resuscitated to original equipment manufacturers’ standards’ and those that qualify will be concessioned to the private sector, with
clear targets for energy availability and operations.
Additional conditions include that:
- Eskom may only borrow to fund investment in transmission and distribution. No new generation projects may be funded.
- Any funds raised from the sale of non-core assets must be put towards debt relief.
- The debt relief can only be used for debt repayments and interest.
- Eskom may not make any adjustments to remuneration that will negatively affect its financial position.
Eskom is the highest-profile problem in the SOE stable, but we think that Minister Godongwana is also sending SANRAL, Transnet and the others a clear message that they can no longer expect the indulgence shown by
his predecessors.
These bail-outs have naturally increased government’s debt burden. The projected peak in the debt to GDP ratio has been pushed up and back, from 71.4% in 2023/24 to 73.6% in 2025/26. The unexpected severity of load shedding will inevitably push this peak higher, but we think it can still be accommodated although it is unlikely to be smooth sailing. In the short-term, the long end of the yield will still experience some challenges, but compared to peer countries, it sticks out. The most important point from our perspective is that the shape of the curve is intact: we are within sight of a peak in the ratio of government’s borrowing to GDP from which it harvests its revenues.
Conclusion
It should be clear that we strongly disagree with the prophets of doom who are writing off SA as a failed state and who consider its government’s liabilities to be uninvestible. We think that investors who allow their heads to be turned by the current wave of sensationalist pessimism will miss a great opportunity to earn good returns on bonds, the pricing of which now reflects a significant amount of bad news.
The currency has been one of the main release valves for pressure. It has been crushed in recent weeks and we believe strongly that it is massively undervalued, as the graph below indicates against our EM peers.
At the same time, we are not blind to the challenges that SA faces. The yield gap between SA and US for benchmark 10-year bonds implies a bond risk premium of 730 basis points which in line with the median over the last 12-months which were volatile. We recognise that a risk premium is justified to reflect our sub-investment grade rating, recent grey listing, load shedding and other headwinds to economic growth. But these are well-established challenges which the market has long since discounted. To assume that they must be discounted again makes no sense to us.
The long-term trajectory for SA’s government finances will be decided by political events far beyond our expertise, but, over a tactical horizon, valuations matter (unless we are entering a failed state scenario, which is not our base case). We are convinced that SAGBs are cheap in absolute terms and relative to their peers. As the following chart illustrates, the markets have singled out SA as the least-attractive issuer in the EM group. This feels undeserved. SA has had no IMF bail-out, South African pension funds are not obliged to prescriptively buy government bonds (as they are in other EM countries) and SA’s hard currency debt position is smaller and more serviceable than that of its EM peers.
The chart not only illustrates SAGBs’ cheapness relative to their EM peer group, but also the absolute value that they offer on a currency-hedged basis. Investors can effectively earn a 7.2% 10-year yield in US Dollars while the US Treasury curve is offering 3.6%. We regard that spread as a handsome reward for the idiosyncratic risks that investors assume by lending money to the South African government. With markets having discounted heavy headwinds, including rand weakness, stickier inflation, grey listing, load shedding, low demand from foreign investors in particular, long end supply with new 2053 maturity bond and National Treasury revising growth prospects lower, cheap valuations are now justified. It is backed by an attractive double digit carry relative to EM peers, making the asset class a great diversifier.