Retain exposure to SA bonds – but nervous investors should keep duration short
South African investors should maintain a cautious exposure to local bonds until after the election
South African investors should maintain their existing exposure to local bonds but do so with some level of caution until there is greater economic clarity after the 2019 general elections.
There are likely to be nine months of market uncertainty in the run-up to next year’s elections as the government battles to meet expenditure targets. But there are also reasons for optimism as the new regime has sent positive signals on fiscal prudence.
In September for instance, it was announced that R50bn of expenditure would be prioritised to boost economic growth and create jobs. This is essentially moving existing money around and will not add new funding pressure on the fiscus.
After the elections, Stanlib expects some confidence to return resulting in an uptick in the investment cycle. With this additional capacity, extra funding will be needed, particularly by state-owned enterprises. Corporate SA will therefore also issue more paper. This added supply is expected to lead to only slightly rising yields.
If we consider that the bond market effectively prices future inflation and expected supply in the form of government borrowing, then the current yield of about 9.2% on 10-year bonds represents a good opportunity for investors to consider.
If the economy grows as expected next year, the country’s financial position is likely to improve. And if CPI as a measure of inflation stays below 6%, as expected, then current bond yield levels could look more attractive if they remain the same until after the election.
Another factor in SA’s favour is that once growth picks up, we are likely to see the return of international investors who are largely motivated by growth. The currency is also likely to be supportive. We expect the rand/US dollar exchange rate to settle in the R13–R13.50 range under this optimistic scenario.
Emerging markets are currently performing poorly as US treasury yields rise and suck capital back to the US as safer US Treasuries become relatively more attractive. But once the emerging-market dust settles, the markets are likely to recover and SA will certainly be better placed to benefit.
Despite our more positive outlook than other market participants, we acknowledge that given the current economic uncertainty there will be many investors concerned about their fixed-income exposure.
At this stage, Stanlib recommends retaining exposure but would suggest more conservative investors consider the income fund, which is yielding 9% as opposed to the bond fund yielding roughly 9.5%. Stanlib’s income fund, however, has a considerably shorter duration of 1/2 a year versus the bond fund duration of over seven years.
Due to the income fund’s much shorter duration, should rates rise, the exposure to the higher rates will be far less and capital better preserved. The income fund will benefit by having more instruments that mature more quickly and can therefore be reinvested at higher rates. It is important to note that most assets in our funds are listed, liquid and of higher quality.
Money-market funds are fortunately also offering positive real returns. Money market offers cautious investors a safe place until there is greater policy clarity.
Another important point to note is the unusual behaviour in the spreads of corporate bonds in SA. With the economy in recession, typically corporate spreads over their equivalent government bonds will widen, reflecting the weaker credit position of the company issuing the bonds. But recent market movements have proved different as investors are worried about the future performance of other asset classes, like equities, and have therefore opted for the greater certainty of fixed income, compressing yield spreads over government bonds and making them less attractive to fund managers.
As one of the largest fixed income managers in SA, Stanlib is in a unique position to engage corporates directly on specific deals. In some instances, we have achieved better yields for investors by dealing directly with those in need of funding rather than chasing expensive corporate listed bonds.
While SA is going through a turbulent time with many factors affecting the bond market both positively and negatively, we do not operate in a vacuum. The global scene, and particularly the US market, has a marked influence on yields all around the world. The US has been the beneficiary of strong fiscal stimulus and tax cuts at a time when the economy was already firing on all cylinders.
The result is fear of an overheating economy and the potential for US rates to keep rising to levels higher than current market consensus. US treasury yields are expected to keep rising for the foreseeable future. This is a wild-card factor that needs to be watched carefully as it has the potential to disturb the apple cart for emerging markets and for SA in particular.
This article was paid for by Stanlib.