Fixed Income Investors Can Benefit from South Africa’s Distorted And Steep Yield Curve

Fixed income markets have been through a tumultuous year. The rate cuts associated with efforts to contain the economic fall-out of the Covid-19 pandemic, together with worries about South Africa’s fiscal position and investor preference for low risk options, have driven distortions in the local yield curve. The current environment offers opportunities for fixed income investors to secure equity-like returns at lower risk levels, provided they are willing to look further out along the yield curve.

The impact of the pandemic induced exceptional market conditions
The Covid-19 pandemic necessitated that governments take extreme actions. Entire populations were confined to their homes and people’s interactions were limited to those closest to them. As a result, economic growth in South Africa came to a grinding halt. Globally, policymakers were forced to take

decisions that weighed the cost of human life against that of economic progress. This was no different in South Africa, where there are significant concerns about the sustainability of government debt levels.

Additionally, the South African Reserve Bank (SARB) has cut the repo rate five times since the start of the pandemic, delivering a cumulative 3% in rate cuts. At 3.5%, the policy rate is the lowest it has been since 1965. The SARB was cutting rates even as local inflation sped to the lower bound of the SARB’s target range, bottoming out at 2.1%. At the time of writing, it was still below the targeted midpoint of 4.5%. Against this backdrop, with many variables changing at the same time, we saw the 10-year government bond yield rise above 12%, something that has not happened since 2002. And the 10-year inflation-linked bond yield spiked very briefly to 6%, before settling around the 4% to 4.5% range. The repo rate cuts also helped to keep short-term rates well anchored, with 1-year negotiable certificate of deposit (NCD) rates bottoming out at 3.375%.

Investors reacted to market developments
A dynamic that played out last year was the flow of money from higher- to lower-risk funds. In total, 2020 saw R145 billion in outflows from balanced and high-equity funds, while income funds received R249 billion in inflows throughout the year. This flow of money from higher-risk funds to lower-risk funds also implies a movement from investments further up yield curves positioned in longer-maturity instruments to lower-risk investments positioned in shorter-maturity instruments.

With concerns around a possible sovereign debt crisis building and investor preference for shorter-dated instruments increasing, there was a very sharp sell-off in longer-term instruments. Consequently, multiple distortions arose: a sharp divergence between short- and long-term yields (the difference in yield offered by various points on the same yield curve became exaggerated) and a sudden increase in the yields of long bonds.

Putting fears around Government’s fiscal position in perspective
Before being able to make any decisions in these kinds of conditions, critical questions needed to be answered. Government’s fiscal position is a relevant concern – and one that bears closer scrutiny. Therefore, we investigated whether it would be possible for a country in a vulnerable fiscal position, like South Africa, to return to a sustainable position.

Our research shows that a recovery is possible. Government’s chosen path of budget cuts and spending reallocation would be the first of many steps needed to head in the right direction. These measures would not be enough on their own, however, and would need to coincide with a revival in economic growth prospects, for which private sector participation would be key. As growth starts to increase, tax receipts will rise and Government’s borrowing requirements will decline. Simultaneously, GDP will increase, resulting in the debt-to-GDP ratio potentially declining fairly rapidly.

The safety in high starting yields on steep curves
High starting yields are incredibly powerful from the perspective of buying with a margin of safety. By locking in a high starting yield, investors are less exposed to changes in yields moving against them, while earning a higher yield. When high yields are combined with steep yield curves, as is currently the case in South Africa, the risk-return trade-off becomes extremely compelling. Under this scenario, if nothing changes, returns from bonds are boosted by a decline in yield as the term of the bond reduces.

The effect of the 10-year bond ‘rolling down the curve’ to 9% would be a return of 16.63% in one year. In their article Being paid to wait John Gilchrist and Mikhail Motala explain that highly attractive dividend yields are also set to reward patient investors in equity markets.

Case studies on the impact of high yields and roll-down potential
The benefits of both high yield and roll-down potential are best illustrated with a real-life example currently held in our fixed income funds. The R2032, a government bond maturing in 2032, currently trades at a 9.7% yield. If nothing changes over the next two years (which we believe is plausible), this bond will deliver 12.5% comprised of the yield plus the benefits from the roll-down. The attractive risk-return trade-off available from these instruments is evident from the pay-off profile below, which shows the annual return over the next two years, under various assumptions.

To illustrate further how high yields can attract investment and in so doing drive returns, we look to a position held in our funds this year. The R186 government bond started the year as a 7-year bond yielding 8.2%. Following the bond sell-off in March, yields subsequently spiked briefly above 11%. This is a very attractive and high starting yield, especially when combined with a very steep yield curve. Throughout the year, as opportunities at the short end of the yield curve became crowded out, more money started to flow further up the yield curve. This caused the yield curve to flatten and the bond’s yield to decline 1.5%, and led to the R186 generating a return of 15.4% for the year. This was comfortably ahead of both the JSE All Share Index and cash, which returned 7% and 5.4% respectively over a comparative period – a very good outcome for fixed income clients.

Opportunities for fixed income investors
2020 saw market dynamics drive distortions across yield curves and offer fixed income investors a unique set of opportunities. There were very real risks that needed to be assessed and we continue to monitor them on an ongoing basis. However, we believe these conditions have offered opportunities to invest with a high margin of safety. In addition, steep curves have meant that if market dynamics result in flatter curves, there is the added possibility of significant capital gains. We have positioned our funds to take advantage of this, and anticipate our investors will be handsomely rewarded in the future.