In the first quarter of 2018 the South African bond market gained an impressive 8.05%. What makes this performance even more noteworthy is that the JSE was down 5.97% over the same period.
This rally is very much an indication of the changing political and economic dynamics in the country. It started just before the ANC conference in December, at which Cyril Ramaphosa was elected party president, and has gained momentum based on what has followed since.
Yields on 10-year South African government bonds have fallen sharply from 9.27% on the day before the ANC meeting to their current levels around 8.05%. This has pushed prices higher.
“What’s happened is the pricing out of political risk and everything associated with that,” says Jonathan Myerson, head of fixed interest at Granate Asset Management. “It started at the conference and gradually developed as things were being clarified and we could see a move away from uncertainty.”
How it all changed
The head of fixed income at PSG Asset Management, Ian Scott, says that there were a number of key factors that have driven this move. The first was Ramaphosa’s election, followed by the February budget that offered important fiscal consolidation.
“The VAT increase was also good for bonds because if you think of government finances, whatever doesn’t come from taxes has to be found in the bond market,” says Scott. “So higher VAT reduces supply.”
In early March National Treasury also cut the size of its weekly bond auctions by a third. Government is therefore borrowing a lot less than it was.
“Most people in the market thought that Treasury would reduce the size of the auctions, but what surprised us is how soon they did and the size of the cut,” says Myerson. “It is quite an aggressive move, so maybe they are bullish about their ability to cut expenditure even further.”
Moody’s decision to not only keep South Africa’s credit rating at investment grade, but to also improve the outlook to stable was also very supportive. Although yields didn’t move significantly since the market was expecting the decision to keep the rating steady, the change in outlook was surprising and further supported the growing positive sentiment.
“Finally you had the South African Reserve Bank (Sarb) moving to a less hawkish stance and cutting rates last week,” says Scott. “So you have had a confluence of all these factors that are really bullish.”
This has also happened at a time when the global environment is favourable for emerging market assets.
“We are seeing economic growth across the US, Europe, China, Japan, and that is good for commodity prices and emerging market currencies,” says Scott. “A stronger rand supports lower inflation, and that in turn supports lower bond yields.”
All of this has led to a point where Myerson believes that the risk premium that was being offered in local government bonds throughout 2017 and most of 2016 has now been unwound.
“At current levels, our bond valuation models suggest that the local bond market is offering no risk compensation,” he said in a recent note to clients.
This doesn’t mean that he believes everyone should be dumping their bond holdings, but by Granate’s valuation methods South African government debt now looks slightly expensive.
“What we have to learn over and over again, is that foreigners looking at emerging markets want something a bit special,” Myerson says. “They want a crisis to give them an opportunity to get in. If I look at basic valuation metrics against other emerging markets on a rolling basis, I don’t think South Africa is particularly appealing to them right now. Most of the appeal has been priced out.”
That doesn’t mean that foreigners believe South Africa has normalised entirely, but they don’t see the same level of risk any more. This is clear if one compares the 8.05% on local 10-year government bonds to the 12.35% being offered on 10-year bonds in Turkey.
Scott however still believes that there is value for South African investors looking for above-inflation returns.
“We take a medium- to longer-term view of inflation, and we believe that the Sarb is credible in sticking to its inflation mandate,” he explains. “In fact it wants to be more hawkish. In the past it was targeting the upper end of the inflation band, around 6%, but it has now clearly stated that it wants to move inflation expectations closer to the midpoint, around 4.5%. If it can engineer inflation expectations lower and you get closer to 5% for some time, your 10-year bond yield of 8% is giving you a real return of 3%, and that is not bad.”