In this article we assess potential returns from South African fixed bonds. We account for the bear argument that hinges on risks in the system but we juxtapose these against sound inflation targeting by the South African Reserve Bank (SARB) and cheap asset valuations.
The SARB targets an inflation level in South Africa of between 3% and 6% – current inflation is at 5.1%. Historically, SA bonds with a duration around 10 years, have delivered inflation beating returns of approximately 2%. Consequently, with the SARB’s inflation band of 3% to 6%, investors should expect returns of about 5% to 8% annually. Currently however, the proxy bond, the R186 (8y SA bond) is trading at a yield of 8.93% relative to inflation of 5.1% – a spread of almost 4%. Considering the SARB has been exceptional at their inflation targeting mandate, the obvious question is why do SA bonds offer such high yields? We believe this can be accounted for as follows:
- High SA consumer debt levels combined with poor economic growth – South African consumers are indebted to the tune of 70% debt to their annual disposable income. Debt repayments substitute other areas of potential expenditure thus gnawing away at the country’s economic growth. It should be no surprise that SA GDP is expected to only be 0.6% in 2018, rising to a mere 2% in 2020 – significantly lower growth than most other countries.
- SA’s twin deficits – the national budget deficit has remained very high since the global financial crisis in 2008, ranging between 3.9% and 6.3% – it is currently 4.17% – this implies that the country spends between 3.9% and 6.3% per year more than the revenue it generates from taxes. Other emerging markets have an average deficit of 1.4%. The result of the high budget deficit is that there is a growing burden of Government debt – our debt to GDP has risen from 30% to 55% in 10 years. In addition to the budget deficit, our current account is also in deficit – we effectively run twin deficits in South Africa.
- Higher US interest rates – the US has made it clear that they intend to continue on a path of normalizing interest rates. Higher interest rates results in money exiting emerging markets and retreating back into the ‘safe-haven’ USA. This is negative for the rand and our inflation.
Those bear arguments against SA bonds should be interrogated against various bond-friendly views, which include:
- Low SA inflation that is exceptionally well managed by the SARB.
- An undervalued ZAR – we calculate purchasing power parity to be R12.20 to the US$.
- Undervalued SA bonds – our analysis reveals that the market has already priced in an investment downgrade of SA bonds. The following demonstrates our point:
- A fair value for the US 10 year bond in our opinion is 3.4% – this assumes 3 more rate hikes in the US and inflation of 2.25%.
- An inflation differential of 2.9% between SA and the US (we believe US inflation will reach 2.3% and SA inflation 5.2%).
- A fair value credit default spread of 220bps – assuming we remain just above junk status as per the Moody’s rating (Baa3).
From these levels, we can calculate that the SA 10y government bond’s fair value level is 8.5%. However, if we assume an investment downgrade, then the CDS spread would probably rise to 300bps – implying a fair value bond yield of 9.25% – exactly the level that bonds are currently trading at. We show this in the attached graph.
Our conclusion is that bonds are negatively priced and should Ramaphosa’s efforts succeed in stabilizing SA’s debt whilst stimulating GDP growth, investors will be rewarded with above average real returns.