A year ago, 10-year South African government bonds were yielding a little over 8.0%. At the height of the March market crisis, however, yields blew out to 12.4%.
They have since retracted to 9.3%, but the outlook appears unfavourable.
‘The single biggest risk facing domestic bond investors is domestic growth,’ said Daphne Botha, portfolio manager at Futuregrowth Asset Management. ‘The forecast for this year is showing -7% GDP growth. That is a terrible number for this country. It is unprecedented in the recent past.
‘Why is that a problem for bonds? The implication is that government revenue will drop. Companies are failing, people are unemployed, and not spending as much as they used to. Less spending means less VAT for government. Companies failing means less corporate taxes. And people losing their jobs means less personal income tax.
‘In order for government to balance its books, it will have to come to the bond market and issue more bonds, or go to the money market and issue more treasury bills,’ added Botha. ‘That is the negative component for fixed income yields.’
At the February budget, Treasury forecast a debt-to-GDP level of between 65% and 72% over the medium term. That, however, was before the Covid-19 crisis.
Now, debt-to-GDP is forecast at between 80% and 100% this year.
‘The thing we need to concern ourselves with is not that number in itself, but how it impacts bond yields,’ said Botha.
Futuregrowth’s projections are that yields on 10-year government bonds, which are currently around 9.5%, could climb as high as 14% next year. The chart below shows Futuregrowth’s modelled yields (in teal) against historical bond yields (in red). It also indicates the firm’s fair value estimates out to the end of next year.
(Click to enlarge)
‘The risk of bond yields going higher is incrementally more than bond yields staying the same or going lower,’ said Botha.
On top of this, foreign ownership of local bonds has been declining – from a peak of 43% of the market in 2018 to below 31%. This falling international demand potentially places additional pressure on yields.
There are, however, three, positives for investors.
The first is inflation, which, in Botha’s view, has moved ‘structurally lower’ in South Africa. Historically, inflation was the biggest driver of local bond yields, although fiscal risks have grown more prominent in recent years.
Nevertheless, if inflation remains low, that has a dampening effect on yields.
‘The second big positive factor affecting bond yields is the current account balance,’ said Botha. ‘It’s still negative, but we are moving towards a neutral or positive current account balance.’
The most significant positive, however, is the high real yields at which bond yields are already trading.
‘While the story is negative, we mustn’t forget what is already in the price,’ said Botha. ‘If you look at the 10-year rate, you can see it is well above its 10-year average. That is telling you this market is pricing in a lot of risk already.’
(Click to enlarge)