SA bond market is riding the wave of risk
By Ryk de Klerk
THE MASSIVE recovery of the rand since April last year and the big drop in South Africa bond yields – bond prices increase when yields fall – saw the FTSE/JSE All Bond Index returning 62 percent in terms of US dollar and 33 percent in rand. But what are the prospects?
The rand recovered most of the lost ground since being slaughtered after the downgrades by credit rating agencies in March last year and the outbreak of Covid-19 in the same month. By the end of April the discount of the rand against my derived emerging market currency index based on equity market weights, widened to about 24 percent from 10 percent in January 2020.
Finance Minister Tito Mboweni’s Medium-Term Budget Policy Statement in October last year, together with the easing of the coronavirus-induced lockdowns soothed the markets while Biden’s victory and successful development of Covid-19 vaccines saw the discount of the rand to the emerging market currency index closing to 7 percent currently.
The current discount is roughly in line with the average since Eskom started to switch off the lights in early 2019 until January 2020. In my opinion, it indicates that the narrowing of the rand’s discount to the emerging market currency index has probably run its course as load shedding is here to stay for the foreseeable future.
It will take a major event or extremely positive announcements for the rand to erase the discount and even trade at a premium to the emerging market currency index. Yes, events such as president Ramaphosa’s election as president of the ANC in December 2017 and his then promises which at that stage instilled hope and confidence in South Africa. A major improvement in the country’s credit rating may do the job but it is not on the radar screen yet.
Strong commodity prices due to the reflation by developed countries are likely to buoy emerging market currencies through end 2021. The relatively high short-term interest rates in emerging markets compared to Japan, Europe and the US will also continue to support emerging market currencies as investors seek to profit from borrowing capital in countries where interest rates are low and investing in currencies paying high interest rates – the so-called carry trade. That is, unless the next black swan event occurs.
I expect the rand to track my implied emerging market currency index for the rest of the year but the rand’s movement could fluctuate widely as you never know what the politicians are up to.
South African government bonds were slaughtered after the downgrades by credit rating agencies in March last year and the outbreak of Covid-19 in the same month that saw the South Africa 10-year government bond yield surging to more than 12 percent.
The yield gap between South Africa and US 10-year government bonds surged to 11.3 percent in March 2010 compared to a close of 7.4 percent at the end of the previous month. The yield gap has closed to 7 percent as the South Africa 10-year government bond yield dropped below 9 percent.
But the prospects of a significantly lower yield gap are limited.
The nominal 10-year yield spread between South Africa and the US, given the former’s credit rating, is approaching the curve of BRIC (BRICS ex South Africa) countries’ spreads compared to their respective average credit ratings (Fitch and S&P). Brazil’s credit rating is similar to South Africa’s rating and the former’s yield spread to US bonds is 6.5 percent.
The yield spread between South Africa and the US is also in line with the curve of African countries’ yield spreads to US bonds compared to their respective average credit ratings.
Therefore, all other things being equal, the South Africa/US bond yield spread may perhaps close the gap with Brazil with the South Africa 10-year government bond yield falling by another 100 basis points in the short term. What is most concerning though is that the average BRIC 10year government bond yield bottomed in June last year at 5.2 percent and is at 5.9 percent, tracking the upward trend in US bonds.
Although emerging market currencies will be buoyed by strong commodity prices with the reflation by developed countries and China, inflationary pressures as a result of higher input costs are likely to put further upward pressure on long-term bond yields in the BRIC countries. South Africa will not be spared though.
Yes, Mr Market’s message is clear. The bear market in global bonds is already under way. Bond prices are heading south as long-term interest rates rise.
It is, therefore, evident that the bull market in long-term South African government bonds is on its last legs. Major ratings upgrades by the credit agencies will be needed to re-rate South African bonds relative to the other BRICS markets.
I will not be surprised if foreign investors in SA bonds will shorten the duration of their SA bond funds in order to reduce downside capital risks.
Mboweni, take note. The South African bond market is almost priced to perfection. Any wrong move in your Budget speech could bring the approaching bear market in South African bonds forward.
Ryk de Klerk is analyst-at-large. Contact [email protected] His views expressed above are his own. You should consult your broker and/or investment adviser for advice. Past performance is no guarantee of future results.
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