ADRIAAN PASK: Behind the bond yield spike
There are many reasons bond yields at home and abroad have surged, but even if the Fed starts to cut interest rates in 2024, you’ll still need a strong stomach for the capital market rollercoaster
Movements in the bond market have prompted media headlines over the past year. In South Africa’s case, the higher yields have reflected higher repo rates and poor sentiment regarding state finances; in the US, they have reflected the higher interest rate environment and fears around inflation.
If we look at the sustainability of South Africa’s state finances it’s no surprise that local bond yields have remained elevated. Our debt-to-GDP ratio is at 72.7%, and is set to rise to 77% in the next few years, not least because of the continued underperformance of state-owned enterprises (SOEs).
The yield on the 10-year local bond recently reached 11.5%, which is similar to what one would expect for long-term equity returns. But while we believe the market is still concerned about Eskom, Transnet and government debt more broadly, we think the impact of load-shedding is likely to be less severe in the coming year, and that interest rates have likely peaked.
The silver lining with South Africa’s government debt is that only a small portion of it (about 12%) is due over the coming four years, which means lower reinvestment risk than in the US (where 46% of the debt is due soon). Still, as debt matures, new debt is being issued at higher prevailing yields. This is a problem for many countries.
The recent MTBPS confirmed our view that South Africa has a perpetually negative relationship with debt, characterised by a strong undertone of crisis management
The recent medium-term budget policy statement confirmed our view that South Africa has a perpetually negative relationship with debt, characterised by a strong undertone of crisis management. That is, we continuously issue new debt to dig ourselves out of the same hole.
It’s not news that South Africa’s public finances are under strain. Latest data indicates the country may face a significantly bigger than expected budget deficit because of falling tax revenues, and soaring spending, coupled with poor fiscal discipline and a lack of sufficient growth.
This toxic brew is reflected in the current risk premiums for local bonds. Usually, the long-term return required for South African bonds is inflation plus 2.5%. Given that the long-run inflation target is 4.5%, we would expect a nominal return of 7%. But that risk premium is at multidecade highs of roughly 4%, due to the factors outlined above. In other words, higher sovereign risk pushes up the required returns to compensate investors. It’s likely a touch overdone.
The problem is that South Africa will battle to raise more debt if it fails to generate enough growth to offset the debt burden. We desperately need to establish a more positive debt dynamic, where debt is seen as something that accelerates growth, not as a lever for emergency funding.
Instead of asking ourselves how much debt is required to solve our SOE headaches, we should be asking which projects will contribute the most to growth and create the most jobs. And then, how we can use funding to prioritise those projects? The balance between these two mindsets is tilted too far towards crisis management.
As for the US, bond yields have risen to reflect higher interest rates. After spending most of the year below 4%, yields on the benchmark 10-year US treasury note rose to 4.98% in October, the highest level in more than 16 years. The market expects the US Federal Reserve to maintain rates at 5.5% until mid-2024. After 2024, moderate rate cuts of about 75 basis points are expected. But only time will tell whether inflation will be contained to justify these cuts.
We expect US debt could keep rising despite having already surpassed $33-trillion, or 129% of GDP
However, US fiscal policies have also caused US yields to increase. The US fiscal deficit has increased significantly since the debt ceiling agreement in June. We expect US debt to keep rising despite having already surpassed $33-trillion, or 129% of GDP.
By 2024, new debt issued by the Fed must increase by more than $700bn (to more than $3-trillion) to narrow this deficit. That is a big wave of new government bond issuance that the market will have to absorb.
Growing treasury supply, rising interest rate premiums and the pricing of higher terminal rates have worked together to drive up yields. Furthermore, global liquidity is dwindling, corporate leverage is rising and US business bankruptcies have started to accelerate. If these conditions persist, economic stress may become so severe that, despite the Fed’s commitment to raise rates, the economic reality of a hard landing may drive it to reverse direction.
A last factor here is that South African yields are underpinned by US treasury yields. As US rates move higher, so too should other bond yields around the globe. The bond markets are trying to digest a multitude of complex issues related to monetary and fiscal policies, but until it becomes clear where these are headed and what the impact will be, markets are set to remain volatile.
* Pask is chief investment officer at PSG Wealth
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