South African Fixed Income – Skewing the Odds in Your Favour - Angles & Perspectives Q3 2023

South African fixed income – skewing the odds in your favour

As investors in local fixed income assets, we aim to provide capital protection for clients and earn risk-adjusted yields that outpace inflation over the life of the investment. In addition, we want to be able to buy fixed income assets when there is a higher likelihood of yields subsequently moving lower (and prices rising) opening the optionality for capital returns – known as buying with sufficient margin of safety. There are few topics that engender as much debate as the case for investing in government bonds, particularly in the current environment where yields have continuously moved higher (and prices lower). The issue is highly emotive, because it is a reflection on the management of our country – something that we are all very passionate about.

It can be very difficult for investors to distinguish between the emotive aspects – the obvious signs of fiscal mismanagement and frustratingly slow progress in areas of national importance – and the investment case. Here, like with any other investment, we have to consider the investment case for government bonds objectively and unemotionally.

Tilting the odds in your favour by buying with a margin of safety

South Africa’s current debt is around 70% of gross domestic product (GDP) and is now forecasted to reach 80% next year. A major source of concern for investors is that interest costs are a growing portion of total spending by National Treasury. In addition, while the National Budget in February made conservative assumptions regarding commodity prices, a sharp fall in key commodity prices, combined with worsening load shedding, meant that revenue collection estimates have not been met.

Fixed income and government bonds in particular are extremely liquid, pricing quickly as new market information emerges. Investments in overcrowded parts of the market, especially those benefiting from positive sentiment, likely reflect these optimistic views in their prices. The odds are skewed against investors in these assets as, if these positive expectations are wrong, investors could lose substantial money as the asset prices plunge. If expectations are met, investors don’t necessarily make much money. This highlights the importance of not overpaying for an asset.

Conversely, we believe SA government bonds fall into the category of uncrowded, unloved assets with significant pessimism built into yields (prices). In our view, this tilts the odds in patient investors’ favour to achieve an excellent outcome – even in a muddle-through environment where the market continues pricing SA as a poor destination of capital. At current yields, investors earn CPI + 7% p.a. if nothing changes, but also get the optionality of significant capital gains if the environment improves marginally.

Unpacking South Africa’s debt profile

National Treasury has repositioned the National Budget to reflect the anticipated lower growth and related revenue shortfalls over the next few years. Further, they have indicated that their primary goal currently is to limit the growing interest bill on new issuances. Our current average interest bill is approximately 8% on our debt. New debt issued into the bond market ranges from 9% to 12.5%, which puts upward pressure on the interest bill. National Treasury began issuing 19% more Treasury bills every week (< 12-month securities) to cover the shortfall. These yields average between 8.5% and 9.25%, lowering the impact of new issuances on the interest bill. Money market funds and banks (for capital purposes) have significant demand for Treasury bills and the issuance has been positively received.

National Treasury decreased the weekly issuance of inflation-linked bonds and has not (yet) increased nominal bond issuance. South Africa has very limited US dollar debt and limited debt maturing in the next four years (roughly 12% of total bonds in issuance), implying a slow grind upwards in the average interest bill from the current average of around 8%. This is a very important factor, because sizeable maturities can substantially increase the interest bill.

National Treasury also continues to manage the debt maturity profile by redeeming shorter bonds and switching these further out on the curve. Switch auctions have been very well received so far and the regular weekly auctions remain well oversubscribed (more buyers than bonds available) at the current yields. Given these factors, we do not believe we will experience a debt default in the near term. Despite the deeply negative sentiment towards these bonds, the likelihood of capital preservation still remains high.

PSG’s award-winning fixed income capability

Our thorough research and independent thinking, as outlined in this article, have contributed to our all-round investment success – with our fixed-income funds also performing extremely well.

At the Raging Bull Awards hosted this year, the PSG Diversified Income Fund won Best SA Multi-Asset Income Fund for straight performance and the Raging Bull trophy for the Best South African Interest-bearing Fund over three years. The PSG Income Fund won Best SA Interest-bearing Short-term Income Fund on a risk-adjusted basis over five years. (All awards for the period ending 31 December 2022.)