Over the last week a fair deal of concern has been raised about foreign selling of South African bonds. To the end of July, foreigners had sold more local bonds than they had done over the first seven months of any year since 1998 according to Bloomberg.
These outflows began in May and accelerated through June and July. As the graph below shows, there has now been a noticeable outflow from South African assets this year.
It is, however, important to put this in context. Foreigners have been net buyers of South African bonds for almost a decade. According to figures from National Treasury, foreigners owned only around 11% of South Africa’s total bond issuance in 2011. By the first quarter of 2018, this had grown to a peak of 43%.
The outflows over the last few months have only reduced this to around 37%.
“When you talk about billions of rands, it is large amounts of money, but it’s fractions of South Africa’s total debt,” explains Albert Botha, the head of fixed income portfolio management at Ashburton Investments. “It’s not positive, but it’s not as if foreign holdings have gone from 40% to 20%, which would be catastrophic.
“These are concerning trends, and it is clearly affecting our bond pricing and our currency, but it’s not as much of a crisis as some people would like us to believe.”
In fact, as Ian Scott, head of fixed income at Momentum Investments, points out, there is reason for the market to see this reduction in foreign holdings as “not a bad thing”.
“In the face of a possible ratings downgrade, you don’t want to have a massive foreign overhang that will hit your bond market when everyone wants to get out,” he notes. “Not that I’m convinced that all the foreigners will leave if there is a downgrade, since our real yields are high, but there will be a knee-jerk reaction.”
It’s also important to bear in mind that South Africa isn’t the only country that is experiencing foreign selling of its bonds. Investors are reducing their exposure to emerging market assets in general as concerns have grown around the trade friction between the US and China, and global growth in general.
“South African bonds don’t live in isolation,” Scott points out. “Globally there is a move out of risky assets into more safe haven assets.”
This is most obviously reflected in the price of gold climbing from $1 200 per ounce at the end of April, to over $1 500 today. That is a 25% jump.
This global risk aversion doesn’t, however, explain all of the foreign selling. Outflows from South Africa have been more exaggerated than those from some of the country’s emerging market peers as concerns have grown about South Africa’s fiscal position, sustained low growth in the local economy and the threat of a downgrade from Moody’s.
“We have probably been hit harder than we would have been if the news had been in isolation,” says Botha. “It’s not just the general global malaise. There are some South African-specific factors.”
There are still buyers
What’s also important to consider is that there are still plenty of buyers for local bonds. Even though there was a larger than normal bond auction this week on top of continued foreign selling, local buyers have been willing to step in.
“The real yields on South African bonds are still attractive given the risks, particularly when compared to other asset classes,” Scott argues. “So more and more local investors have been prepared to get in.”
The real yield refers to the return that investors are earning from bonds above inflation. Currently, this is between 4% and 4.5%.
This is attractive in an otherwise low return environment, and this is reflected in the bond holdings of local multi-asset funds. According to the Alexander Forbes Manager Watch survey, the average allocation to South African bonds in the large balanced funds it covers has grown from 14.68% at the end of 2013 to 19.19% by the end of 2018.
“If you also look at where our current real yields sit compared to many of our peers, its also seems that South African bonds look attractive against many of our peers just on a standalone basis,” Botha points out.
As the graph below indicates, the real yield available in South Africa is higher than any of these other emerging markets. The country does however carry the twin risks of its high budget and current account deficits.
South African bonds are therefore now looking fairly cheap, and while they could still get cheaper, this does create a margin of safety for investors. Particularly because a lot of bad news is already priced in, including the chance of a downgrade.
“Should the global market turn more positive, the bond market will benefit, although we do seem to be constrained by the local economic situation,” says Botha. “I think that South African bonds do offer value, but barring some significant institutional and structural progress, I don’t foresee us having a significant bond rally outside of changing global sentiment.”