Fixed income: With all the risks, is there value?

Covid-19 came as a huge surprise and there’s likely be quite a lot of adaption and dynamism going forward, says Ninety One’s Peter Kent.

RYK VAN NIEKERK: The South African bond market suffered one of its worst quarters ever in the first quarter of this year. During this quarter, Moody’s finally downgraded South Africa’s credit rating to sub-investment grade, bond rates spiked and foreign investors sold off more than R50 billion worth of bonds. Then Covid-19 struck, and the world as we know it in many ways went haywire. Peter Kent is the co-head of South African & Africa fixed income at asset management group Ninety One. Peter, thank you so much for joining me. The bond market used to be very predictable, but a lot has changed during the past few months. How do you interpret the reaction of the bond market to what we saw during the first few months of this year?

PETER KENT: Howzit Ryk. Thanks for having me. I mean, you mentioned Moody’s in there – when you look back at this quarter, or that first quarter, in 20 years’ time, I think the one-liner will be, ‘Ah, Moody’s downgrade. That’s why we had such a poor month or poor quarter’. And ironically, you know, given how much that Moody’s downgrade had been anticipated or feared for so long, I would actually say that that was one of the lesser factors that drove the bond market in that quarter. I think when you look back over that quarter the main determinant was, as you mentioned, it was foreign selling, significant outflows from our bond market, but that wasn’t on the back of Moody’s, that was on a global liquidity preference. So, you know, across markets, across the globe, investors were looking for liquidity in the face of this Covid virus.

And why was it so severe? So when I look at it, I think when you look at the market set-up going into the year, I think there was vast consensus that it would be a pretty good year. We had just come out of a trade war between the US and China and people were looking for some sort of bounce-back, central banks were easing and sort of providing liquidity left to right and centre. So I think there was vast consensus for it to be a reasonable year for all asset prices. I think investors were generally set up for that coming into the year. And then we got T-boned by the Covid virus. I don’t think anyone anticipated it being such a significant economic problem so quickly. And then on top of that, you have a market micro-structure problem, which has evolved since the global financial crisis where banks have been disintermediated.

So banking regulation, post-GFC [global financial crisis] has meant that a lot of sort of, you know, the intermediating flow between investors and end-users and all of these types of things, you know when you’re selling a bond, buying a bond, buying equity, selling equity, a bank used to sit in between them, but between the different participants and, you know, sort of dampen the volatility and then post-GFC, these bank’s balance sheets have been regulated. So they weren’t able to sit through this period. Intermediate flows dampen liquidity as much as they would have in the past. So you had that sort of triple whammy hitting the bond market. You had people [who] were potentially overweight South African bonds and not too concerned about the outlook. The Covid virus hit everyone with a huge surprise. And then you had a market that really struggled to absorb the need for liquidity. And as a result of that, you had what you had, which necessitated unprecedented action from the Reserve Bank.

RYK VAN NIEKERK: Peter, the R186, which is one of our benchmark bonds, is currently down at 7.36%, which seems to be relatively strong. Can you put that into perspective for us in the context of the environment you just described?

PETER KENT: Yeah, sure. So I think the first thing I would say is [that] it does seem quite low, but if you consider where that yield got to in the peak of the crisis in March, it got up into the 12% yields. So there’s been a significant retracement. It’s actually now retraced through the levels that we found ourselves [in] going into Covid. I would say the biggest comparative to that is cash rates. You know, when you look at cash rates down around 4%, heading sub 4% with potential Reserve Bank easing coming down the pipe, something like 7.3% for a five-year bond doesn’t seem like a bad pickup. So I think for a bond that shorter-dated, the main sort of tethering valuation factor is what the Reserve Bank is doing. For a 30-year bond, further out, the main factor that influences that is things like global sentiment and what National Treasury is doing with the fiscus.

RYK VAN NIEKERK: But where does this leave our bond market? Many people have seen it as a safe haven, as a very predictable investment. It does not seem to be the case anymore. Do you think the risk profile of our bond market has changed in recent months?

PETER KENT: I wouldn’t just say in recent months. I think one of the major developments in our bond market over the years post-global financial crisis is the amount of foreign participation. I mean, in many ways, it’s the success of our bond market that foreign ownership got into, very close to 50% at one stage. It shows that we have a reliable Reserve Bank and that we can issue longer-dated bonds in our own currency. So that foreign participation has definitely led to more volatility, so it’s led to our bond market being more susceptible to global sentiment. So I would think that’s been a phenomenon that’s been evolving for some time, but again, that’s a sign of success. But I think when you look at March price action and you look at quarter one, you can definitely say that South African bonds aren’t riskless, they’re very rightly so.

I think the fiscus is in quite a precarious position at the moment. So we never view our bond positions in isolation. We always look at our bond position and the risk component of it – as I mentioned, [those] sort of valuations look fantastic at the moment – but you can’t ignore that risk factor that you mentioned. So we are always looking at our portfolios for ways to manage that risk. One of the best ways to manage that risk actually is to keep a small allocation of your portfolio offshore because when bonds do sell off as they did in March, or like they did in Nenegate, for example, the currency tends to send off too, so a small allocation offshore is often a very nice way to get the kind of yield that you want out of the bond market without exposing yourself too much to capital movements.

RYK VAN NIEKERK: But on 24 June, which is in two weeks, Tito Mboweni the minister of finance, will table a new emergency budget and there may be dreadful news in that budget. Do you think that may move the market at all?

PETER KENT: I think that’s a very, very important goalpost. We’ve been discussing it in the team quite a lot lately. It’s obviously a very important market factor. And I think the difficulty of it is how accurate that budget can actually be. How accurate can you be on growth and taxable costs at the moment? If the finance minister shows a deficit that’s better than expected, then there’s potentially two angles to that. Is it good news or is it unbelievable news? You have to then sort of analyse it based on the limitations of data currently. I mean, we currently think that we’re going to have a deficit of around 13% of GDP this year. And I think the market is based in at similar type levels. If the finance minister shows something materially better than that, and that’s based off GDP contracting by 8% this year, if the finance minister shows something significantly better than that, then we’re all going to say, well, well, how do you know, like, you know, we really are, we’ve got data for one month of the current fiscal year. It’s very hard to determine how the future’s going to evolve. So it’s going to be very difficult for him to develop an emergency budget that’s accurate. I think there’s going to be quite a lot of adaption and dynamism to expenditure going forward. And you know, the mini-budget in October is as equally important as more data evolves.

RYK VAN NIEKERK: Yeah. It’s going to be really interesting, indeed – 13% deficit. just saying that number puts a chill down my spine. I think the debt-to-GDP ratio will also spike over 90%, which is also not a good number, but as you say, this is what people expect. And in the context of that, we won’t see economic growth this year. We will actually see a significant decline. How important is the underlying health of the economy and how that shapes bond market returns?

PETER KENT: I think it’s the most important thing in any South African asset price at the moment, including bonds. Our ability to grow was struggling before this Covid virus. So the need to reform and create an economy that can grow was a priority. And the economy was already in recession when the virus hit and the need for it now [is] even more urgent because, as you mentioned, debt-to-GDP with these kinds of deficits will be at a 100% pretty soon. It’ll be a lot sooner than you think, which is fine if you can grow. I think we all know from personal circumstances, you know, your mortgage is a function of your income. So if the country can grow, generate tax revenues, this is something that is very, very manageable, but if it can’t grow, we’re already at debt-to-GDP levels that are unaffordable. So the underlying economy is the factor. That also then feeds into the social compact to political stability. If we can’t grow, there’s going to be unsettled social dynamics in South Africa which the rating agencies always point to. So, you know, that is an underlying dynamic that that can be solved only through growth and a dynamic economy.

RYK VAN NIEKERK: That also creates a dilemma – you know markets do not only react on positive news or negative news, but you also need to have a perspective of what’s going to happen in future. And currently, there are so many thunder clouds hanging over our future. I can’t foresee we will get any good news in the foreseeable future, the next few months, if not years. How should you look at bonds as an asset class from that perspective?

PETER KENT: Well Ryk, I think one of the interesting points, you know, with these numbers, these numbers are scarily big. As I mentioned, 13% of GDP deficit, potentially with risks that it’s wider. The deficit was forecast to be 6.8% from the February budget before this virus, which was already an astoundingly big number. But I think one of the positives in South Africa – and the fiscus doesn’t have a cash flow problem currently, they are raising those bonds; there is a foreign and local demand for bonds at the weekly auction – so there isn’t a cash flow problem in the fiscus right now. And I think that’s quite astounding when you think of the shock that went through the system in March. The fact that National Treasury managed to fund themselves in local currency throughout the whole process and that it doesn’t have to issue a whole lot more bonds than would have been anticipated is a big positive for the bond market.

You can imagine the bond market is a demand-supply dynamic, just like every other market. And the supply comes from the National Treasury. If there isn’t a huge cash flow problem, an immediate cash flow problem, then the bond market can lean against that. The bond market can then say, okay, I’m not expecting a whole bunch of supply coming up. So even though the deficit is quite large and quite scary because we have such a deep local bond market where there is pension demand, foreign demand to some extent, the National Treasury can fund themselves and then demand and supply come into balance. So from a bond perspective, valuations look good. Inflation is low. We haven’t spoken a lot about inflation, but inflation is low. That’s the ultimate enemy of a bond. For a local currency bond, it does not default – that’s the risk; it’s the fact that inflation over the next 30 years is going to remain under control.

And we’ve got a very credible Reserve Bank who are very, very steadfast in keeping inflation under control and inflation is going to surprise to the downside for this year and next, and as a result of that, a 10-year yield of 9%, it looks fantastic against inflation that looks like it’s going struggle to get to 4%. So the real yield and the valuation argument looks fantastic and National Treasury don’t [have] – there isn’t a massive cash flow problem, it’s a solvency problem, further out. It’s that growth dimension that we mentioned, meaning that South Africa is, slightly, is facing a solvency problem, further out. So I don’t think bonds on their own, as I mentioned [and as] you mentioned earlier, they do have risks. They’re not riskless, there are a plethora of local and foreign risks at the moment and a bond position that’s carefully managed with some sort of offshore allocation, if you can, or there are other [options] – if it’s a domestic-only portfolio, you can invest in inflation-linked bonds, which are slightly more defensive, or you can invest in bonds that are shorter-dated and are more tethered to what the Reserve Bank is doing and less dependent on what National Treasury is doing. There are ways to manage the risk of these attractive valuations.

RYK VAN NIEKERK: Yes. As you say, I think the prospects for inflation [are] really, really good, but of course, inflation is linked to the interest rate. We’ve seen aggressive interest rate cuts since the beginning. What do you think the future holds for the interest rate? Do you think it may be cut even more as some economists foresee?

PETER KENT: So we were looking for good news in the previous answer, one of the fantastic pieces of news over this whole crisis is you’ve seen the rand appreciate significantly this year. I think, we came into this year with the rand around R13 to the dollar, and we got somewhere very close to R19 to the dollar in the midst of the crisis. That is not normally an environment where the Reserve Bank is cutting rates. That is normally in an environment where the Reserve Bank is having to hike rates because the rand appreciation is resulting in inflation being higher. So we’ve been lucky, along with a whole bunch of other emerging markets, that we’ve been given the inflation space to cut rates throughout this whole process. Why is that? Well, the oil prices suffered quite considerably. Part of that was the Opec price war that sort of developed around March, April.

And then part of that is there’s been a huge drop off of global demands in oil. People are in lockdown, they’re not in planes and they’re not in cars. So that oil price decrease has helped us from an inflationary perspective. And then the hit to economic activity in South Africa is real. You’re seeing it in house prices, rental prices, inflation, in those kinds of categories [that were] already low going into this. And those are very persistent categories. So those are all dragging inflation lower, which has allowed the Reserve Bank to reduce the rate by 250 basis points since the Covid virus hit. And when you think of that as a percentage of people’s mortgage and interest payments, that’s a significant relief. So the Reserve Bank has said, listen, we’ve done a lot, which they have done. They’ve cut a lot. They’ve intervened in the secondary market, which we totally support.

They’ve provided extra liquidity. They’ve provided a backstop to banks through this loan guarantee programme. So the Reserve Bank has not been asleep at the wheel. They’ve done a huge amount. They are now sitting and waiting and seeing the effects of what they’ve done. They’re going to meet again in July. We anticipate that they’ll cut 25 basis points in July. For them to cut another 50, we think they would have to be surprised both on growth and inflation. They’ve got growth for this year of down 7% or so. And then they’ve got inflation forecasts around 4%. So we need to see inflation and growth supply to surprise to the downside for us to see a 50 basis point cut. So our core view is another 25 basis points in July and then in September. So 50 more in total, but we would need to see the economy surprise them to the downside, which we anticipate – our forecasts suggest the economy and inflation will allow the room for them to cut another 50 by the end of the year.

RYK VAN NIEKERK: But the cuts by the Reserve Bank this year have been emergency cuts. I don’t think we’ve ever seen anything like this in South Africa, in many, many decades. How do you think it will influence the cycle or put differently, how long can we remain at these record low rates?

PETER KENT: It’s a great question. And an element of that debate as well [is] how low can we go in terms of rate, and how long can we stay this low? I think from the question of how low we can go, the Reserve Bank, I think there are some participants on the MPC [Monetary Policy Committee] who think we are very close to the lows and how low we can go, and then there are some participants like us who think we could potentially go about 50 basis points lower. Then how low we can stay is really a function of local and offshore factors. So if the global economy evolves in a manner that is insipid and it keeps rates low across the rest of the globe, especially in the US and in places like Europe, then the air cover for us to keep our rates low is there.

So there is that factor. When you look at the economic damage that has been done in Europe, we had the ECB [European Central Bank] commenting on how inflation is just not forecast to come off the floor for some time. So rates are going to remain negative there for some time. In the US they’re going to remain close to zero for some time as well. So I think there’s air cover there for rates to remain at this level for at least six months to a year from offshore factors. Then domestically, the factor that will determine whether rates move up from here is how the economy rebounds. If the economy rebounds surprisingly positively, which I doubt, you could see rate hikes by early next year, but that would require a sort of almost miraculous turnaround in the economy. So I think these low rates are a feature for at least the next six months to a year, and probably further out because of the economic impact. I mean, it’s going to take us two or three years to recover the output that we’ve lost through this.

RYK VAN NIEKERK: Just lastly, listed property. It’s one of the sectors on the JSE that has really taken a beating over the past few years. And especially over the past few months, what are your prospects for a listed property?

PETER KENT: As a bond manager, we look at listed property slightly differently from an equity manager. We look at it as a bond versus property type decision. So for us, it’s [a question of] is it a better prospect than bonds? I think the big issue with a listed property at the moment is the valuation question. When we spoke about the R186, it’s quite easy to come up with a valuation proposition because, as I mentioned, it’s quite, it’s tethered to the Reserve Bank and cash rates. So it’s conceptually quite easy to figure out that that actually looks like good value. But when you look at a listed property and you look at the question mark over dividends, over rentals over the future of the property, and we’re all working from home now, so is there a need for retail and commercial property going forward? The valuation question is a lot harder to answer. It’s a lot more complex.

As a result of that, what looks like exceptionally good valuations – if you changed a few parameters around rental collections or vacancies, that could quite easily eat into that valuation. So from us, it’s an income-generating asset that’s not really declaring income at the moment. So we’ve kept an underweight position in listed property for some time. It’s been more on the economic outlook and the lack of demand for property. And we haven’t really been using the opportunity lately to increase our position materially. I think if you think bonds are volatile, the listed property is just in another league. So the risk factors, as you spoke about in bonds, are quite prevalent in listed property. So we still keep an underweight position in our portfolio because we ultimately think that bonds are a better place to get your yield.

RYK VAN NIEKERK: Peter, thank you so much for your time today. That was Peter Kent, he’s the co-head of SA & Africa fixed income at Ninety One.

Brought to you by Ninety One.



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