The downgrade of South Africa’s sovereign credit rating to junk status by Moody’s late in March 2020, while lost to some degree in the noise around Covid-19, fundamentally changed the dynamics driving the local fixed income markets. The question for fixed income investors is whether this development offers any opportunities, given the global backdrop of low inflation, low interest rates, low global bond yields and the South African Reserve Bank’s (SARB) bond purchasing activity.
Moody’s cut South Africa’s sovereign credit rating based on a culmination of factors. The credit ratings agency assessed the country against four rating components as shown below:
Source: Moody’s, Nedbank CIB
For the last few years, the SARB was extremely hawkish and focused on reducing inflation to the middle of the 3% to 6% target despite weak economic growth. As the Covid-19 pandemic unfolded, their approach shifted from inflation targeting to supporting economic growth in the context of zero demand and subdued inflation, with SARB cutting interest rates by 2.5% since mid-March. When liquidity dried up, the SARB stepped in with bond purchases in the secondary market to reduce excessive price volatility.
The downgrade to junk status makes it more expensive for government to borrow, which is reflected in higher bond yields. But at the same time, the National Treasury is likely to have to step up the pace of borrowing (bond issuance) as the economic contraction will result in tax revenue shortfalls.
Cash is currently far from king
In times of uncertainty, the default reaction for risk averse investors is to move into cash. With the cuts in interest rates, real interest rates are currently negative and money market returns do not provide protection against inflation. Consumer demand is at very low levels and unlikely to recover soon, so real interest rates could stay low for an extended period and cash is unlikely to give investors a real return for the foreseeable future.
Credit spreads on corporate debt have widened as the risk of corporate defaults increases due to the challenging economic climate, reflecting the increased risk linked to these instruments.
On paper, longer-dated bonds look attractive as the increased sovereign credit risk has led to higher yields, but the term risk on these bonds is excessive in our opinion.
Opportunities in shorter-dated fixed coupon and inflation-linked bonds
Ten-year bonds are yielding around 9.5%, which is more interesting if government can manage the challenges it will face and inflation is kept in check. Yields in the seven- to ten-year range look acceptable for the risk provided.
The credit downgrade also created high real-yields on short-dated inflation-linked bonds. Inflation needs to average below 2% for these bonds to underperform on a nominal return basis compared to fixed bonds, which we consider unlikely, and even if this were to be the case, returns will exceed the required real return hurdle. Despite subdued demand, the potential sources of price inflation could come about as a result of cost-push factors, rising import prices or an increase in raw material prices. In this case, inflation-linked bonds would deliver a sound return.
The Northstar *SCI Income Fund is well positioned in the current environment
The Northstar SCI Income Fund is currently weighted strongly towards inflation-linked bonds, spread across all bonds on the front end of the yield curve, and split between senior bank paper and government bonds.
Northstar’s ability to move with relative ease in the market has meant that we are lighter on credit exposure than our peers and have largely avoided the impact of widening credit spreads, which had a significant effect on returns. The credit we hold is senior bank paper, as close to the front of the queue as possible to reduce credit risk.
Despite the risks currently evident in the bond market, there are still opportunities. Even if conditions worsen from this point, the front end of the yield curve has the potential to outperform cash and generate a reasonable return for fixed income investors.