Philip Liebenberg, Portfolio Manager at Abax Investments, discusses whether the current high yields available on SA bonds outweigh the increased fiscal risks in the SA fixed income market.
Is the local bond market still attractive?
Money market yields are 3.5%-4%, which is probably inadequate for most investors as an income with little real growth. Nominal bond yields are returning a yield of 9%-9.5%, which is quite attractive. Money market rates are driven by monetary policy with rates being the lowest in a decade. The budget deficit was expected to be around 15% and ended up at 12.3% with good revenue overruns due to better export mining royalties. Government stuck to their expenditure targets, so this was positive news. We’re all looking for some fiscal consolidation in the medium term. In terms of bond issuance, a flood of bonds came into the market and yesterday Treasury announced that the issuance would decrease by about 1 point. If you look at the nominal bond market, the total issuance will come down to less than 5%.
Fiscal risks still exist
In terms of the MTBPS, we were heading to a debt to GDP of 100%, which has been revised down to just less than 90%, which is good news. We can’t ignore the SOEs, which have a lot of debt and can easily add another 20% to that number, which is a concern. We need some fiscal consolidation and negotiations on the public sector wage bill to go well, with low increases going forward. Our debt service costs as a percentage of tax revenue is over 20%, which is also problematic. From a risk and credit perspective, this is very different to where we were 10 years ago. Our risk has definitely increased with our average budget deficit on the high side compared to emerging markets. Our average debt service costs as a percentage of revenue is also on the high side relative to our EM peers. Given this higher risk, investors should require a higher risk premium.
It ultimately comes back to valuations. We see fair value at about 9%-9.5% on the bond market given the inherent risks. If you have a debt to GDP of between 70% and 90%, investors would typically require a real yield of between 4% and 6% and our bonds are in that vicinity. Being part of a global economy, cash flows given the massive global fiscal stimulus will affect us. But, we have seen reflation trade coming through and the fear of global inflation. On the back of that, we’ve had rising global bond yields, which is a headwind for SA bonds. In the last month or so, the weakness has largely been due to increasing global real and nominal yields. If you look at what’s available to investors, SA looks attractive on a relative basis so we should see some support for the local debt market.
We use breakeven inflation to look at relative value. On the longer end of the curve, breakeven inflation is around 6%-7%. We see long-term inflation being closer to 4.5%-5%. On a real yield basis on the nominal curve, we look cheap in the long term. We do, however, need fiscal consolidation and our bonds and curves are pricing in this uncertainty down the line.
The Rand looks fairly valued
From a PPP basis, the Rand is fairly valued. If you adjust that for some of our fundamentals, we think the Rand is slightly overvalued at these levels. We’ve been a huge beneficiary of this global wash of liquidity. With the Rand being a proxy for emerging markets, we’ve done exceptionally well, also on the back of good commodity prices.
Bond yields are high at 9.5%. At those levels, we think it’s fairly valued and we will add bonds at higher levels. We’re a bit more conservative on bond allocation compared to the market average, which reflects the risks. For us, it’s about diversification and looking at opportunities in the different sectors of fixed income and whether you’re being compensated for the risk you’re taking. We think that even though bond yields are high, on balance you are being compensated for the risk, but we’ve got a tough few years ahead of us. We’re neutral on nominal bonds, but we do like inflation linked bonds and added these last year at real yields of 3.5% and 4%. Protecting the real value of capital is important and we have a bias towards real assets, which is why we added inflation linked bonds. We think the stars are aligned for higher inflation and that central banks would like this. We should be prepared in the fixed income market to earn negative real rates where inflation could run higher than bond yields. Central banks can enforce yield curve control and is something we could see down the line from the ECB and possibly the US.
What can we expect from SA inflation over the next 12 to 24 months?
We expect rates to stay flat. The window for cutting rates further, given global rates and monetary policy, is still open. The market is anticipating anything between 75 bps and 1% over the next year. We think that’s too aggressive and that lower inflation is giving SARB the opportunity to stay lower for longer. The next move in rates will be up and won’t be unexpected.
Does listed property offer good yields compared to fixed income yields?
We do have property exposure, but this is below 3% in most of our multi asset funds. We did add to our property exposure in Q3/4 2020, albeit from a low level, but we felt we were being compensated for the risk and that a lot of companies were being indiscriminately sold down. With property not being very liquid, the chance of dislocations is bigger. Our preference is for quality companies with good balance sheets and sustainable growth over the medium term.