SA is in a position to lure investors to high-yielding bonds
Foreigners have not participated actively in our auctions for almost two years but there are reasons why that could change
It is tempting to see only the negatives regarding SA (and other emerging markets), but when it comes to local sovereign bonds we believe several positive developments are being overlooked in this time of fear. The SA Reserve Bank has cut the repo rate by 200 basis points, which is expected to deliver R80bn in stimulus to the real economy. The Bank further reduced the capital and liquidity regulatory requirements of banks, enabling them to extend credit to business and individuals requiring support during this period.
Because SA did not experience cyclical credit extension, our banks entered this period relatively well capitalised on a global scale. Monetary policy appears to have been effective to date in easing liquidity concerns in the market, reducing the risk of another liquidity-induced sell-off. Importantly, both the Reserve Bank and the banks are now fully able to act counter-cyclically due to years of prudent policy action and balance sheet management.
The government released a fiscal plan indicating a R500bn package to underpin the economy, in line with some of the larger support packages we have seen globally at about 10% of GDP. This included a R200bn guarantee scheme enabling the banks to extend credit, with the government expected to guarantee roughly R32bn of potential losses. This scheme plays an important role in opening up credit markets that have been largely frozen.
We have spent significant time modelling the potential impact of a lower GDP base for the year, and the effect on tax revenue will undoubtedly require additional borrowing. We have also considered the potential for additional pressures on the fiscus from support for state-owned entities. The broad assumption is that the additional funding requirement places too much pressure on the local fund management industry and banks given the lack of support from foreign investors in our local bond auctions.
Foreigners have not participated actively in our auctions for almost two years, after averaging about 40% of auction issuance since 2012/2013 and taking up more than 80% in the preceding two years. It is difficult to predict whether foreign investors will continue to shun our auctions. However, there are a few aspects to consider.
First, real yields are high (relative to other emerging markets and history), and it is not a given that foreign buyers will stay on the sidelines given the depressed yields of developed market bonds. A crucial variable is whether the government will restore the credibility of our budgetary framework, and recent indications that the stimulus package will need to be offset with austerity measures is a positive development.
Second, we believe the government can reduce the supply of longer-dated bonds by increasing the issuance of Treasury bills at significantly lower rates where demand consistently exceeds issuance levels at the weekly auctions. The government can access this benefit due to the favourable long-term debt structure in place.
Third, whether through multilateral funding or additional offshore bond issuance, SA can access funding other than in the local markets, as noted in the release of the R500bn stimulus package.
As of April foreigners had sold about R176bn in government bonds since 2018. This has affected the valuation of local assets, with the yields on our 10-year bond trading close to 9.5%, our credit default swap spread now trading at 4.6% from a low of 1.6% at the end of 2019, and the rand losing the most against the US dollar in the emerging-market currency basket (close to 25% down since the start of the year).
In conjunction with these depressed valuations, it is important to consider some of the mitigants for SA relative to other emerging markets:
- Our floating rate currency tends to react to stabilise the current account as rand weakness translates into greater exports. Importantly, the Bank does not seek to intervene in foreign exchange markets to protect the value of the rand, increasing the value of this buffer. While the rand has weakened more than peers, this is counter-intuitively a potential positive as other central banks have used limited foreign reserves to buffer the devaluation of their currencies.
- Regulation 28 limits the offshore allocation of local funds to 30%, with a 12-month grace period to correct should this limit be exceeded. In previous periods of rand weakness, this acted as a self-correcting mechanism for the rand as capital is eventually repatriated into the local market.
- SA’s low levels of expiring sovereign debt in 2020 and 2021 provide increased room to act fiscally. SA can leverage off a strong debt structure (long dated with low foreign currency denominated debt) to issue debt that could be extremely attractive to investors, with real yields among the highest on offer globally and well in excess of yields on developed market bonds.
The Covid-19 crisis has caused dislocation in prices within financial markets. There were a number of technical and therefore potentially temporary aspects to the recent sell-off in sovereign bonds. Investors should demand higher yields compared with the globe when lending to our government due to an expected increase in debt and the deteriorating fiscal situation. However, our yields were high going into the Covid-19 crisis and some recent developments, such as falling inflation and rate cuts, are bond supportive.
Real yields are an important building block for inflation-proof wealth for the long term, and they are available to investors now. Short-term real rates are no longer attractive. Long bond rates have always been indicative of economic and inflation pressure points, and this time is no different. However, the extent to which investors are being rewarded with a rate well above inflation points to an opportunity to reap benefits from the dislocation that a crisis inevitably brings.
• Sankar is a fund manager at PSG Asset Management.