South African finance minister Malusi Gigaba took on the bond market, and he is losing.
As investors digested Gigaba’s intention to close a yawning budget gap by flooding the domestic market with an additional R122 billion ($8.6 billion) of bonds over the next three years, benchmark yields soared as much as 56 basis points to 9.42%, the highest in 19 months. That’s already closing in on the government’s own bad-case scenario of an 80-point jump in yields – and things could get a lot worse.
The market and rating companies “will hate” an increase in the debt ceiling, rising bond issuance, the lack of spending cuts, and the widening deficit contained in the budget proposals, Investec Asset Management said in a note to clients.
Foreign investors, who hold 41% of the country’s R1.97 trillion of local-currency bonds, dumped R5.1 billion of the debt in the hours after Gigaba delivered his medium-term budget statement to lawmakers on Wednesday. That’s the biggest one-day outflow since September 2011, at the height of the European debt crisis — but it’s small compared to what could happen if the debt gets downgraded to junk, forcing South Africa’s exit from Citigroup’s World Government Bond Index.
That would spark outflows of as much as R200 billion as investors that track the index divest their holdings, according to a recent estimate by JPMorgan Chase & Co. If that happens at a time when rising rates in developed nations curb demand for emerging-market assets, yields on benchmark bonds may climb close to 11% and stay there, according to the worst-case scenario painted by South Africa’s National Treasury.
“A downgrade and exclusion from the WGBI seems as though it is a foregone conclusion in the market,” Reezwana Sumad, an analyst at Nedbank Group, said in a client note. In addition, “South Africa’s vulnerability to global and emerging-market risk sentiment cannot be ignored. Any turn in foreign sentiment would yield large outflows from the bond market, and consequently higher yields,” she said.
S&P Global Ratings and Fitch Ratings stripped South Africa of its investment-grade foreign-currency assessment in April, citing concerns about policy uncertainty and lackluster growth, just days after Gigaba replaced Pravin Gordhan as finance minister. The deteriorating debt trajectory threatens to trigger a downgrade of the local-currency debt rating to junk by S&P and Moody’s Investors Service. Fitch already assesses the local-currency debt as sub-investment.
Gigaba’s budget proposals, which include lifting the projected debt ceiling to more than 60% of gross domestic product, from 54%, represent a “change in direction away from a focus on fiscal consolidation,” Fitch said in a statement on Thursday.
Before the budget, the median forecast of analysts surveyed by Bloomberg was for the 10-year bond yield to end the fourth quarter at 8.75%. The implied forward yield on Thursday stood at 9.47%, suggesting the market is already repricing for the risk of a downgrade.
“The market has now re-priced to the realisation that a downgrade is likely,” said Malcolm Charles, a portfolio manager at Investec Asset Management.
To be sure, any further yield increases could be capped by investors holding off in anticipation of a central-bank rate hike as the weakening rand fuels inflation. Market expectations on policy, as measured by forward-rate agreements, swung from a cut to an increase over the next 12 months. The currency slipped 0.1% on Friday to 14.25 per dollar, bringing its decline this week to 4.5%.
“The prospect of a sharp increase in local-currency bond issuance in the upcoming fiscal years is conducive to higher yields,” said Absa Bank strategist Mike Keenan, who predicts the 10-year yield will fall back to 9.07% by the first quarter of 2018. “But curve-steepening is being restricted by heightened rate hike fears associated with the weaker rand backdrop.”
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