THALIA PETOUSIS: Searching for bond yields after volatile year

Bonds locally and offshore had another volatile year in 2023. Measured from the price high in January 2023 to the price low in late September, the SA 20-year government bond fell from 81c to 69c on the rand, a 15% clean price deterioration.

While interest coupons cushioned just more than half of that drawdown for bondholders, it was still undoubtedly a tumultuous period for the fixed interest market. In performing the same calculation for US treasury bonds of an equivalent maturity over that period, the returns were similar even when measured in rand terms.

For much of the year, there was simply no safe place to hide for a long-duration fixed-rate bondholder, highlighting the current importance of diversified fixed-interest exposure across floating-rate paper, inflation-linked bonds and money market instruments, as is held in the fund at attractive yields.

In the final quarter of 2023, US and SA bonds staged a recovery from those pricing lows. Part of the rationale underlying this move is that the market is eagerly anticipating the start of the US Federal Reserve’s interest rate cutting cycle, with the expectation for the overnight rate to fall from 5.5% to closer to 4% in 2024.

Fed chair Jerome Powell does not explicitly endorse such an outlook, instead emphasising his desire to pause and evaluate the effect of higher borrowing costs on the US economy and to assess whether inflation is falling back to the Fed’s 2% target. What is interesting beyond this is that 4% is still a healthy dollar yield, and one that has not been enjoyed by US fixed-interest investors since 2007. In addition, 4% is certainly not a return the FTSE/JSE all bond index has been able to deliver over the past five to 10 years in dollar terms.

Would such a move in the US to short-term rates of 3%-4% still entice foreign investors to participate in the SA market to the degree they did from 2012 to 2018 when they desperately hunted for a decent yield in a world of virtually zero percent rates? This uncomfortable question hangs in the balance for many emerging market (EM), African and frontier sovereigns that became accustomed to issuing a large quantum of debt into a world abundant with easy capital.

Took comfort

As higher developed market rates and large offshore deficits have drained these flows from the periphery of financial markets, the issue of scarcity of capital has taken centre stage. Only when the tide goes out do you learn who has been swimming naked, and several African and EM sovereigns have met their debt demise in the past few years as capital flows wash into the core of financial markets and expose the fragility of fiscal accounts in the periphery.

Another reason for the partial recovery in SA government bonds in November was the delivery of the medium-term budget policy statement. Despite a projected deterioration in SA debt to 75% of GDP in the 2023/24 financial year, the bond market took comfort from the suggestion that the National Treasury will not raise rand fixed-rate and inflation-linked bond issuance to the degree it can avoid doing so.

Yields promptly fell, though the curve did steepen to reflect heightened long-term fiscal risks. Whether fixed-rate bond auction sizes will be increased has become a key issue given that the local savings pool is highly saturated with government paper compared with the historical situation, which has put upward pressure on yields.

Local debt issuance targets did increase by 15% in the 2023/24 financial year versus the February 2023 budget projection, but this will be met with increased treasury bill and floating-rate note auctions, and with the issuance of the new RSA Sukuk bond in the fourth quarter of 2023 that was largely taken up by local banks to be held as high-quality liquid assets against their Shari’ah deposit liabilities.

For the financial year starting March 1, issuance is projected to rise another 11% and 13% more in the year thereafter. Without a return of significant foreign capital flows, this will require the local savings pool to increase its sovereign debt holdings further. The Treasury has asserted that to avoid raising issuance in the sacred cow arena of fixed-rate bonds, it will instead continue to use the floating-rate funding tool (a shorter-dated note with five- to seven-year refinancing risks) and begin to issue inaugural rand green bonds.

Made inroads

It remains to be seen what form the green bonds will take and whether the local savings pool demand will be sufficient to meet supply. While these tools represent a diversification of funding tools, they do not represent a diversification of funding sources.

Where the Treasury has made inroads in terms of diversifying its funding sources and lowering its debt financing costs is via the avoidance of the expensive offshore Eurobond capital markets. The Treasury has been absent from the Eurobond market since early 2022 and has instead made significant progress in replacing that foreign debt with lower-cost financing from sources such as the IMF, German state-owned development bank and the Canadian government.

This is commendable and speaks to the strength of our National Treasury in managing the debt mix and profile despite the mounting burden that is placed on it, with available government cash balances estimated to have fallen intra-month in early December 2023 to below R100bn, a 13-year low, after repaying a large inflation-linked bond maturity.

Heading into 2024 local unit trusts have trimmed their ownership of SA government bonds after reaching close to a record high weighting as a percentage of portfolio exposure. The sustainability of maintaining such a high weighting against the backdrop of tepid growth in the local savings pool is a dynamic we have questioned for some time.

We have also seen a semblance of a return of foreigner inflows into SA government bonds, presumably given their expectation that global policy rates have peaked. While it is too early to extrapolate from this trend of capital flows, it has provided some underpinning to a local bond market that has struggled to attract non-resident inflows since 2018.

• Petousis is fund manager of the Allan Gray Bond Fund.