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Foreign investors have almost constantly been selling SA government bonds over the past three-and-a-half years as the seriousness of the fiscal situation and resultant rising debt levels have become clearer. If anything, this selling has increased over the past year as the already dire fiscal situation was exacerbated by the economic effects of the measures taken to slow the spread of Covid-19. As a result, in addition to the supply from foreign sellers, the government has increased issuance of new debt to fund the rising fiscal deficits. The important question, which many fail to ask, is: who has been buying?
The simple answer can be found in National Treasury statistics. Local banks and asset managers have been buying. But why? These are arguably the most knowledgeable and sophisticated of local investors, surely they can also see the dire state of our nation’s finances, as regularly highlighted by the global ratings agencies and macro economists? What do locals see that foreign investors don’t?
Rising inflation concerns and a weakness in US 10-year nominal bond yields have seen a recent sell-off in emerging-market bonds and currencies by foreign investors. Driven by the anticipation of a rise in US bond yields, the decision to sell was possibly premature. Global financial conditions are still supportive of many emerging-market destinations offering high real yields, such as SA.
We caution investors not to write off SA assets prematurely. Local asset managers generally view both the equity and bond markets as extremely good value. Many managers have actually reduced offshore assets to increase exposure to more favourably priced local assets over the past year.
From early 2020 bank deposits increased substantially as savers looked for safety during this period of increased uncertainty, when the magnitude of the potential Covid impact became clearer. Simultaneously, banks obtained cheap funding from the SA Reserve Bank, which wanted to ensure banks had sufficient liquidity at this time of extreme financial stress.
Demand for new private sector loans reduced significantly as corporates and individuals became exceedingly cautious, delaying capital expenditures that often require bank funding. Banks have thus had excess capital with little pressure to pay up for funding. Medium- and longer-dated government bonds were offering yields higher than many private or commercial loans, and therefore buying government bonds became very attractive for banks.
Local asset managers have also been steadily increasing their exposure to SA government bonds over the past few years as the real yields offered by these instruments, particularly over the past year, look very attractive in a world starved of yield. They have been buying both nominal and inflation-linked government bonds in their multi-asset mandates, where inflation-beating returns are generally the objective. Compared with global government bonds, local money market instruments and corporate bonds, these bonds offer very attractive real yields.
With no pressure expected from global rates and a weak economy, low interest rates are probably here to stay for the next few years, which will directly affect the interest rate SA investors earn on their bank deposits and money market funds. For this reason we believe investors seeking inflation-beating returns on their local income assets should follow the lead of SA professional investors and consider increasing their exposure in the government bond space.
But what about the risk of the government defaulting on the bonds? The probability of this occurring is negligible for rand-denominated bonds. If the need arose, the Reserve Bank could print rand to service these obligations. A second-order effect of this would be higher, possibly much higher, inflation and a significant reduction in the real value of the rand you receive from the bonds. Furthermore, if the Treasury did default on its debt obligations, the returns experienced by investors on their holdings of government bonds would probably be the least of their concerns.
Investors want to gain exposure, but to go all in and buy government bonds may translate to a bumpy ride. Employing an experienced and active income manager to allocate between bonds and other income instruments should afford investors the comfort of a smoother investment journey with attractive risk-adjusted returns. As the most liquid asset in the fixed-income space, government bond allocations can add significant value in the hands of a good asset allocator. Our preference is therefore to invest in the best multi-asset income funds, which enables the fund manager to benefit from the regular cycles of foreign investor fear and greed, rather than using a static allocation to government bonds.
Ultimately, in return for tolerating some shorter-term volatility the potential additional returns that can be earned are significant for income investors prepared to take on a little more risk.
• Hatty is chief investment officer at Stonehage Fleming SA.
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Published by Arena Holdings and distributed with the Financial Mail on the last Thursday of every month except December and January.