Global bond markets – noisy volatility
Fixed income investors have experienced a rollercoaster ride of events since 2012, which is when South Africa’s credit rating started to slide, highlighting the importance of adhering to a set of sound investment principles in realizing required returns without incurring permanent capital loss. There have been a number of unpredictable turn of events, pushing and pulling market prices in all directions, causing investors to doubt whether there is actually a link between price and value.
This brings to mind the parable of the “Farmer’s fortune”, a story about an old farmer who had worked his crops for many years. One day his horse ran away and when his neighbors heard the news, remarked sympathetically “what bad luck”. “Perhaps,” the farmer replied. The next morning, the horse returned home with three wild horses. “What great luck!” his neighbors exclaimed. “Perhaps,” replied the old man. The following day, his son tried to ride one of the untamed horses, was thrown, and broke his leg. Again, the neighbors came to offer their sympathy. “Perhaps,” answered the farmer. The next day, military officials came to the village to draft young men into the army. Seeing that the son’s leg was broken, they passed him by. The neighbors congratulated the farmer on how well things had turned out. “Perhaps,” said the farmer.
Forces behind the moves
In a similar fashion, a number of forces have caused local and offshore bond yields to seesaw from one extreme to the next over the last 6 years. In summary.
- Low yields in early 2012 (accommodative monetary policy, low inflation and slow growth in the US)
- Rising yields in 2013 (tapering of the US quantitative easing programme)
- Falling yields in January 2015 (declining oil price, fear of European recession and slowing global growth)
- Rising yields in 2015 (anticipation of rate normalisation in the US)
- Rising local yields in 2015 (declining credit rating as a result of deteriorating debt metrics, waning growth and the risk of policy implosion due to poor leadership)
- Falling bond yields in emerging markets in 2016 (stabilising commodity prices, weaker US dollar and substantial yield gap between developed and emerging market bonds)
- Falling US bond yields in the first half of 2017 (North Korea related geopolitical risk)
- Rising local bond yields in 2017 (credit rating cut to junk by S&P and deteriorating local fundamentals)
Moody’s and South Africa’s credit rating reprieve
Local bond yields are falling once again, and this time it comes on the back of the latest credit review by Moody’s; South Africa has retained its Baa3 investment credit rating with the outlook changed to stable. This is exactly the news that South Africa needed and justifiably, the bond market is in rally mode. We find ourselves, once again, at a juncture where we, like the farmer and his fortune, need to assess the latest turn of events. What is priced into South African government bonds?
The valuation story around South African bonds
It is reasonable to work out the value of a local government bond based on the required yield spread above a US bond, which compensates you for the inflation differential and the South African specific risk over a particular period. US 5- year bond yield (2.64%) is anticipated to continue rising, as interest rates normalize in America and the consensus view in the market is that yields will reach 3.2% over a period of two years. In addition, the inflation differential between SA and the US, is expected to rise from 2% to 2.9%, as SA inflation rebounds off a cyclical low (4.0% to 5.2%) and US inflation ticks up from 2.2% to 2.3%
The most import factor we can adjust for in the wake of the recent Moody’s credit review is the South African specific risk, which we approximate by the price of a 5y credit default swap (5y CDS). More recently, the 5y CDS spread for South Africa has widened to 161bps, which is between 60bps and 100bps wider than other countries on the same credit rating as SA. Admittedly, the average CDS spreads for all countries are at cyclical lows, however it is reasonable to assume a 5y South African CDS spread of 150bps on a forward looking basis.
The current fair value of the South African 5y bond yield is 6.05% based on the sum of 165bps CDS spread + 180bps inflation differential + 260bps 5y US yield vs. the current SA 5y yield of 7.4%. Looking two years ahead, the fair value yield of the SA 5y bond is 760bps. This assumes no further deterioration in South African specific risk with a CDS spread of 150bps plus an increased inflation differential of 290bps and a higher 5y US bond yield of 320bps. See Table 1.
On this basis, there is scope for the SA 5y bond yield to rally lower in the short-term, however the risks two years out are:
- Low yields in early 2012 (accommodative monetary policy, low inflation and slow growth in the US)
- Rising yields in 2013 (tapering of the US quantitative easing programme)
- Falling yields in January 2015 (declining oil price, fear of European recession and slowing global growth)
With the latest positive Moody’s credit review, it is safe to assume South African specific risk has been contained for the moment, which is our good fortune.
Table 1. South African bond valuations