Can you bet on South African government bonds now? - Prudential

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Can you bet on South African government bonds now? - Prudential
A N A LY S I S
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                                                                    Can you bet on South
                                                                     African government
                                                                             bonds now?

                                                 Roshen Harry
                                                 PORTFOLIO MANAGER

                                       i     KEY TAKE-AWAYS

                                        The SA bond market is facing the         risk to investors is less than many
                                        threat of a downgrade to sub-            believe. Our most likely scenario is for
                                        investment grade level by Moody’s,       some initial strong selling followed
                                        which would expel our bonds from         quickly by buying by investors wanting
                                        the World Government Bond Index          the attractive yields on offer. We
                                        and prompt sales by index-trackers       believe the yields now on offer are
                                        and investors unable to hold sub-        attractive, adequately compensating
                                        investment grade bonds.                  investors for this risk already.
                                        While there are different views of
 Prudential Investment Managers ©

                                        the bond market reaction should this
                                        happen, at Prudential we believe this
                                        is already largely priced into current
                                        bond yields, and that therefore the

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Can you bet on South African government bonds now? - Prudential
A N A LY S I S                                   Can you bet on South African government bonds now?

                                       G
                                               oing into 2020, South Africa faces       Services (Moody’s) of our sovereign
                                               weak growth, persistent fiscal           investment grade rating from Baa3
                                               concerns and a possible ratings          to a sub-investment grade rating.
                                        downgrade. In addition, December’s              This downgrade would result in the
                                        bouts of power cuts have weighed on             automatic expulsion of South African
                                        market and consumer confidence and              government bonds from the World
                                        raised the chances of the economy               Government Bond Index (WGBI). What
                                        moving into a recession. The Medium-            would be the effects of this move?
                                        Term Budget Policy Statement (MTBPS)
                                        delivered in October 2019 forecasts             Possible impacts of exclusion
                                        the public debt-to-GDP ratio to reach           from WGBI
                                        a worryingly high 71.3% in 2022/23,             One view is that this exclusion
                                        with no debt consolidation in sight             will cause foreign investors to sell
                                        – news which was not well received              between US$3 billion and $10 billion
                                                                                        of our government bonds. With these
                                        by the market. Some assert that the
                                                                                        bonds needing to find a home, bond
                                        MTBPS was used as a tool to signal
                                                                                        yields would, as a result, increase
                                        to government the country’s urgent
                                                                                        meaningfully.
                                        need to embark on its reform agenda,
                                        which would boost much-needed                   Another view suggests that the WGBI
                                        growth. This, in turn, would increase           investor exposure to South African
                                        revenue collections over time and pave          bonds is only moderate, and so an
                                        the way for an improvement in public            increase in yields from a WGBI exclusion
                                        finances, ultimately reducing the cost          would be only temporary, as non-
                                        of capital. Whatever your view, it is           benchmarked investors and local fund
                                        clear the fiscal position has added to          managers would snap up the bonds as
                                        the basket of risks which have weighed          they became attractive. A third view is
                                        on the local bond market, given that            that the downgrade to sub-investment
                                        any further fiscal blow-outs would              grade could ease market uncertainty,
                                        result in the government having to              which could result in the stabilisation
                                        issue more debt.                                of government bond yields.

                                        Entering the new year against this              As is the norm in any well-functioning
                                        backdrop, one factor that will be               market, there are clearly a range of
                                        hanging over our government bond                differing views on this topic. By and
Prudential Investment Managers ©

                                        market is the increased risk of a               large, however, investors appear to be
                                        downgrade by Moody’s Investor                   generally pessimistic with respect to

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A N A LY S I S                                     Can you bet on South African government bonds now?

                                        South Africa’s growth prospects and               Inflation
                                        fiscal health in the medium term. That            When looking at bond yields it is
                                        pessimism, we think, is largely reflected         important to consider inflation, given
                                        in the elevated level of government               that it erodes the purchasing power of
                                        bond yields in the local market. This             the returns investors receive over time.
                                        article will try to provide some reasons          The higher a country’s inflation rate is
                                        as to why we at Prudential think South            expected to be (inflation expectation),
                                        African (SA) government bonds offer               the higher the yield an investor should
                                        value for investors at their current              require to compensate for this erosion
                                        yields.                                           of purchasing power. The yield investors
                                                                                          receive after adjusting for inflation is
                                        Prudential’s view on SA government                called the “real” yield. Currently, SA
                                        bonds                                             inflation outcomes show subdued
                                        Considering all of the negative factors           inflationary pressures, much like most
                                        above, our view is that much of the               of the developed world, at 4% y/y in
                                        prevailing pessimistic sentiment is               December 2019, well below the South
                                        already priced into government bonds,             African Reserve Bank’s mid-point
                                        and therefore any potential bond                  inflation target of 4.5%. Meanwhile,
                                        market sell-off will not be as severe             according to the Bureau for Economic
                                        as many anticipate – after all, markets           Research (BER)’s fourth quarter 2019
                                        are forward looking. Consequently,                survey, expectations for headline
                                        we consider these assets to be cheaply            inflation are trending downwards
                                        valued, offering attractive returns in            towards the SARB’s mid-point target,
                                        the medium term (over three to five               now at 4.5% for 2019 (from 4.6%
                                        years). Below I discuss inflation as an           in the previous quarter). Inflation
                                        important factor, as well as three key            expectations for 2020 and 2021 have
                                        measures which support our view                   continued to ease gradually and are
                                        (historic real bond yields, relative credit       at 4.8% and 5.0%, respectively, the
                                        default swap spreads and relative real            lowest levels since 2007, and five-year-
                                        bond yields), keeping in mind that                ahead inflation expectations have
                                        this is not an exhaustive list. These             also declined to 4.9% from 5.0%. Two
                                        measures do, however, form part                   years ago the latter was closer to 6%,
                                        of our investment decision-making                 at the upper end of the SARB’s 3-6%
Prudential Investment Managers ©

                                        process.                                          inflation band.

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A N A LY S I S                                   Can you bet on South African government bonds now?

                                        High real bond yields                           Graph 1 (in the left box) plots the yield-
                                        Looking at absolute yield levels as of 16       to-maturity of our 20-year government
                                        January 2020, long-dated government             bonds since the year 2000 alongside
                                        bonds as measured by the 10- and                SA’s expected annual inflation rate.
                                        20-year bonds are yielding about                The right box illustrates real yield,
                                        9.0% and 10.10% respectively, at                which is the difference between the
                                        the upper end of their trading range            bond yield and SA inflation. They
                                        over the past four years. SA’s subdued          clearly highlight that real yields are
                                        inflation gives investors who buy               at elevated levels compared to the
                                        long-dated bonds the ability to earn            observation period. They are also well
                                        attractive real yields of about 4.5%            above our view of their long-run fair
                                        to 5.6% in the 10- to 20-year tenors,           value (which is around 2.5%). Hence
                                        assuming inflation is anchored at 4.5%          this supports our conviction that
                                        over the term of the bonds. Using               long-dated government bonds offer
                                        the Bloomberg consensus headline                attractive returns over the medium
                                        inflation forecasts for 2020 and 2021           term.
                                        of 4.7 and 4.8% respectively, inflation
                                        is expected to be well behaved in               Elevated relative credit default
                                        the near term. Alternatively, using             swap spreads
                                        BER’s five-year inflation survey, the           Another way to measure how the
                                        longer- term inflation outlook has also         market is valuing South African debt
                                        moderated. Remember that investors              is to compare the country’s credit
                                        are still assuming inflation risk, in           default swap (CDS) spread versus other
                                        believing that the SARB will continue           countries. A CDS can be thought of as
                                        to exercise its mandate successfully            an insurance policy that can be bought
                                        and not lose its credibility by letting         against a default or other credit event
                                        inflation run back to the upper end of          by the debtor. They are essentially
                                        its inflation target band and beyond.           derivative contracts that transfer credit
                                        Should inflation return to the 6%               exposure between counterparties.
                                        level, the real return on long-dated            The higher a country’s credit rating,
                                        bonds would fall to 3% to 4%, but we            the lower the CDS spread (since there
                                        would still consider to be an attractive        is less risk involved in holding their
Prudential Investment Managers ©

                                        return proposition.                             debt) and vice versa.

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A N A LY S I S                                                                                      Can you bet on South African government bonds now?

                                                                                     Graph 1: Attractive real bond returns on offer
                                                        Nominal 20yr bond yield vs inflation                                                               Real 20yr bond yield rises
                                     16                                                                                                   8

                                                                                                                                          7
                                     14
                                                                                                                                          6
                                     12
                                                                                                                                          5
                                     10
                                                                                                                                          4

                                             8                                                                                            3

                                                                                                                                          2
                                             6
                                                                                                                                          1
                                             4
                                                                                                                                          0
                                             2
                                                                                                                                          -1

                                             0                                                                                            -2
                                              Oct  Oct Oct                       Oct  Oct  Oct  Oct Oct   Oct  Oct                           Oct Oct Oct Oct Oct Oct Oct Oct Oct Oct
                                             2000 2002 2004                     2006 2008 2010 2012 2014 2016 2018                          2000 2002 2004 2006 2008 2010 2012 2014 2016 2018

                                                                    SA 20 Year Bond               SA Expected Inflation                                                   Real Yield

                                   SOURCE: IRESS, Bloomberg 31 December 2019

                                                              Graph 2: SA already priced at sub-investment grade by market
                                                                                                       Five-year credit default swap spreads
                                                        600

                                                                                                                                                                                Kuwait
                                                                   Iraq                                                                        Mexico              Chile           Hong Kong
                                                        500
                                                                              Cameroon                                                          Saudi Arabia       China            South Korea
                                                                                                                                                                                     United Kingdom
                                                               Angola                                                           Uruguay          Lithuania                                   New Zealand
                                                                                    Tunisia                                      Colombia                              Ireland
                                                        400                                                                                       Latvia
                                                                   Pakistan                                                                                             Japan                   Finland
                                                                                                                                 Hungary
                                    5y USD CDS spread

                                                                                                                                                                                     France
                                                                      Ukraine                                                                      Peru                                          Austria
                                                                              Kenya                                              Russia                                  Israel
                                                              Nigeria
                                                        300                   Costa Rica                                                              Spain                                      Canada
                                                              El Salvador     Rwanda                                             Indonesia
                                                                   Egypt              Turkey                                                          Malaysia     Slovakia
                                                                                                                                  Bulgaria
                                                                          Senegal                   Oman                           Panama                                                       Australia
                                                        200                                                                                        Iceland         Qatar
                                                                                                            South Africa
                                                                          Bahrain      Guatemala                                  Portugal            Slovenia      Estonia                     Germany
                                                                                                                     Italy
                                                                                    Greece                      Cyprus                                               Czech                      United States
                                                                                                                                 Panama
                                                        100                          Brazil               Morocco                                                                              Netherlands
                                                                                                       Serbia       India                                                                     Norway
                                                                                                Croatia Romania                                 Poland                     Czech              Denmark
                                                                                                                Kazakhstan         Thailand                Belguim                           Switzerland
                                                          0
                                                              B-          B       B+      BB-     BB     BB+    BBB-      BBB   BBB+      A-      A        A+    AA-     AA     AA+    AAA
Prudential Investment Managers ©

                                                                                                                Local currency rating: Median of 3 agencies

                                   SOURCE: S&P, Fitch, Moody’s, Bloomberg 16 January 2019

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A N A LY S I S                                  Can you bet on South African government bonds now?

                                        Graph 2 shows the five-year CDS spreads           “Equally, countries rated in
                                        of investment and sub-investment              the lower range of investment
                                        grade countries, with the latter plotted     grade (BBB-) are trading at CDS
                                        in the shaded area. South Africa’s CDS      spreads of 75 to 125 basis points
                                        spreads are already trading at about            (0.75% to 1.25%), lower than
                                        170 basis points (1.7%, as shown by                            South Africa.”
                                        the red dot), comparable to countries
                                        that have sub-investment grade ratings         economic growth outlook worsen even
                                        of BB. Equally, countries rated in the         more. This could then cause a shift in
                                        lower range of investment grade (BBB-)         market expectations toward further
                                        are trading at CDS spreads of 75 to            downgrades to come, and more bond
                                        125 basis points (0.75% to 1.25%),             market weakness as the government
                                        lower than South Africa. This clearly          would be forced to borrow more.
                                        shows the market is already pricing            Hence the urgent requirement for fiscal
                                        South African debt at sub-investment           responsibility and growth-enhancing
                                        grade.                                         reforms.

                                        Based on this observation, we could            High relative real bond yields
                                        infer that should Moody’s downgrade            Finally, Graph 3 compares 10-year
                                        SA to sub-investment grade, the odds           real bond yields across some of South
                                        of further extended weakness in our            Africa’s peer countries, where our
                                        government bond market are rather              government bonds undeniably stand
                                        slim. There could be initial knee-             out as offering very attractive real
                                        jerk selling following the news of a           yields. Using the S&P long-term local
                                        downgrade, but we believe this could           currency rating, SA has a higher credit
                                        evaporate rather quickly as investors          rating than both Brazil and Turkey,
                                        see a good buying opportunity.                 and can offer highly developed, deep
                                                                                       and liquid financial markets along with
                                        Of course this scenario bars any further       strong macroeconomic institutions that
                                        deterioration in the national fiscus           are viewed as credible by international
                                        that might occur this year, should             institutions; yet it offers higher real
                                        projected debt levels continue to rise         yields to investors. Equally, the graph
Prudential Investment Managers ©

                                        more sharply than expected or the              shows the unattractive (negative)

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A N A LY S I S                                             Can you bet on South African government bonds now?

                                                         Graph 3: SA real bond yields higher than most countries’
                                                                                    10-year real yields
                                                 4.5%
                                                                                                               BB+
                                                 4.0%

                                                 3.5%
                                                                           A-                                              BB-
                                                 3.0%

                                                 2.5%                                          BBB

                                                 2.0%
                                    Real Yield

                                                                                                                                      BB-u
                                                                                  BBB-u
                                                 1.5%

                                                 1.0%

                                                 0.5%

                                                 0.0%

                                                 -0.5%      AA+u
                                                 -1.0%
                                                         United States   Mexico   India      Indonesia     South Africa   Brazil     Turkey

                                   SOURCE: Bloomberg, Consensus Economics 20 January 2020

                                                 real yield on 10-year US Treasuries,                we find that bargains are to be had in
                                                 indicating their poor return prospects.             financial markets when the news flow
                                                 Real returns are even more negative                 is positive and market confidence is
                                                 on most European government bonds.                  high. In a Bank of America Securities
                                                 Although SA’s long-dated bonds could                SA Fund Manager review, the majority
                                                 weaken further, if an investor is willing           of fund managers considered the
                                                 to ride out the volatility over the                 South African 10- year government
                                                 medium term, prospective returns
                                                                                                     bond to be undervalued, and more
                                                 are very likely to be attractive given
                                                                                                     managers were bullish on SA bonds
                                                 the starting yield.
                                                                                                     on a 12-month view than bearish. Yet
                                                 Overweight SA government bonds                      only 25% would buy them at current
                                                 In this article I have highlighted some             levels and the vast majority would
                                                 of the primary risks associated with our            only be buyers at cheaper levels. This
                                                 government bonds that could cause                   indicates excessive pessimism toward
Prudential Investment Managers ©

                                                 investors to avoid them. Yet rarely do              our assets. Yet even though these assets

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A N A LY S I S                                     Can you bet on South African government bonds now?

                                        can become cheaper, we do not have                including the Prudential Balanced
                                        much faith in the ability of investors            Fund, Prudential Inflation Plus Fund
                                        (including ourselves) to successfully             and Prudential Enhanced Income Fund.
                                        time the markets consistently – in                We find that, although these assets
                                        this case, to time the bottom of the              do certainly face some challenges in
                                        market. Hence, for valuation-based                the coming year – including a possible
                                        investors like ourselves we consider              credit rating downgrade – their current
                                        the investment proposition to be an               real yields adequately compensate
                                        attractive one.                                   investors for assuming the risks of
                                                                                          owning them.
                                        Investing is not a sure thing, and no
                                        position is without risk; this is why
                                        we at Prudential have a risk-based
                                        approach to investing. Our approach
                                        is to scale into positions over time,
                                        gradually building our exposure as
                                        assets become cheaper. Currently we
                                        are constructive on long-dated SA
                                        government bonds in our portfolios,
                                        with the capacity to invest further
                                        capital into these assets should yields
                                        rise even further.

                                        At the start of 2020 we are overweight
                                        longer-dated South African government
                                        bonds in our multi-asset unit trusts,

                                     Roshen joined Prudential in 2006 and is the joint-Portfolio Manager of several Prudential funds.
                                     With 19 years’ industry experience, Roshen completed his articles at Deloitte & Touche before
                                     joining Rand Merchant Bank in their Risk and Compliance division. He holds a Bachelor of
                                     Commerce degree and a Post Graduate Diploma in Accounting, both from Rhodes University. He is
Prudential Investment Managers ©

                                     a qualified CA (SA) as well as a CFA charterholder.

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