The COVID-19 outbreak translated into broad-based weakness in emerging market assets as the outlook for global growth and the appetite for risk assets swiftly deteriorated. This resulted in a tough period for our clients, as we have favoured hard-hit nominal government bonds over other areas of the fixed income market. We, however, remain confident that bonds offer an attractive opportunity for our clients, and continue to position our funds to achieve acceptable client outcomes in the best risk-adjusted manner.
PSG Asset Management has favoured the real yields in sovereign bonds
We have favoured nominal government bonds over other areas of the fixed income market. We believe headline inflation will remain anchored over the longer term, due to the credible monetary policy approach of the South African Reserve Bank (SARB). Our positioning was therefore focused on the significant real yield opportunity these bonds offered investors. These instruments, in our view, offered a margin of safety with real yields close to all-time highs and disproportionately high relative to global developed and emerging market bond yields. This implied that yields were compensating for idiosyncratic South Africa-specific structural risks. Our funds were therefore relatively overweight in exposure to sovereign bonds while underweight in corporate bonds and local listed property exposure, which offered poorer valuations, low absolute and real yields and significant inherent credit (default) risk.
The recent upward movement in bond yields has marginally impacted our assessment of intrinsic value and as such offers significantly wider margin of safety to our view that these bonds will continue to deliver attractive returns for clients. In graph 1 below, we illustrate the real yields available in these bonds pre and post the impact of COVID-19 (using a conservative 4.5% inflation rate).
We have carefully considered the risks and opportunities in the domestic sovereign bond market
We recently reassessed our views on the sovereign and macro environment to ensure our clients are compensated with a fair real yield considering the changed global environment. Our conclusion is that the current sovereign curve still provides attractive opportunities relative to other areas of the fixed income market. These bonds now offer an additional 1% to 2% real yield to compensate for the near-term economic shock and its impact on South Africa’s fiscal position.
Evaluating the impact of an economic recession on domestic bonds
The outlook for the South African economy over the rest of 2020 is dire. It is therefore appropriate to consider the impact this is likely to have on the country’s fiscal position. There is a prevailing bear theory that many emerging markets, including South Africa, stand on the edge of a balance of payments crisis and that bond yields could rise substantially. What gives us the confidence that bonds remain an attractive opportunity under the circumstances?
South Africa entered this period in a weak fiscal position with the outlook for debt to GDP and the weight of debt service costs already a concern for investors. Interestingly, it is only two months ago that National Treasury embarked on a more determined approach to fiscal reform, earmarking R150 billion in cuts to Government’s wage bill with a view to restoring the credibility of our budgetary framework. The outlook, however, has now deteriorated significantly with South Africa’s real GDP growth expected to be anywhere between -5% and -10% for 2020 and the main budget deficit to be worse than -10% of GDP. These factors contributed to the rise in domestic bond yields in March 2020 – which saw the 10-year bond yield hitting 13%, 4% higher than the levels of early March 2020!
Understanding the true drivers of the sell-off
Contrary to the narrative, we believe other technical factors were the primary drivers of higher yields in emerging market debt. The biggest driver was the unprecedented wave of foreign selling of perceived risky assets (especially liquid assets such as emerging market debt). Other drivers included liquidity constraints in the asset management industry, margin calls on derivative instruments used in bond funds, and domestic asset class rotations into lower risk products. The sell-off was probably so extreme because these factors occurred simultaneously. Therefore, we believe it was more technical than fundamental in nature.
Reassessing the case for South African sovereign bonds: several positive developments are being overlooked in a time of fear
Given the very visible bear cases for South Africa and other emerging markets, driven by the GDP shock to their finances, it is important to reassess the appropriateness of our views and the likelihood of these tail risks negatively impacting portfolios in the future. Specifically, does the additional real yield compensate investors for these risks, and what mitigants are in place to soften the impact on the fiscus?
- South Africa’s institutions have implemented a co-ordinated and largely coherent COVID-19 plan
Healthcare initiatives: To date, South Africa’s healthcare plan to combat COVID-19 has been viewed as a positive surprise relative to our history of poor policy implementation, even garnering praise from the World Health Organisation (WHO). The plan appears to have been operationally sound with additional emergency funds allocated towards healthcare, achieving positive results and flattening the infection rate curve.
Monetary policy: The South African Reserve Bank (SARB) acted quickly and decisively in an environment characterised by increased uncertainty and fluid information flow. The SARB has cut the repo rate by 2%, which is expected to deliver R80 billion in stimulus to the real economy. The Bank further reduced the capital and liquidity regulatory requirements of banks, enabling them to extend credit to business and individuals requiring support during this period. The SARB has provided additional liquidity to the market, by increasing the number of auctions through which the banks can access cash, as well as lowering the cost and extending the term of these loans. Our banks have also built up capital reserves over the years, as South Africa did not experience cyclical credit extension, entering this period relatively well capitalised on a global scale. Monetary policy appears to have been effective to date in easing liquidity concerns in the market, reducing the risk of another liquidity induced sell-off. Importantly, both the SARB and the banks are now fully able to act countercyclically due to years of prudent policy action and balance sheet management. This is an important consideration when thinking back to previous crises where the SARB was forced to increase rates during a crisis.
Fiscal policy: Government released a fiscal plan indicating a R500 billion package to underpin the economy. The detail has been widely written about with the scepticism that usually accompanies actions by Government. The R500 billion package appears to be in line with some of the larger support packages we have seen globally, at around 10% of GDP, surprising many. It does appear that Government used some manoeuvring within the budget by reprioritising expenditure, delaying tax receipts from corporates and allowing access to R100 billion within the Unemployment Insurance Fund (UIF)’s positive net position. The remaining R200 billion relates to a guarantee scheme enabling the banks to extend credit, with Government expected to guarantee roughly R32 billion of potential losses. Putting these numbers together, it appears the actual outlay for Government is a lot less than R500 billion, which indicates potential multiplier benefits of the schemes introduced.
- There should be sufficient domestic demand for further government issuance
We have spent significant time modelling the potential impact of a lower GDP base for the year, and the impact on tax revenue will undoubtedly require additional borrowing by Government. The broad assumption is that the additional funding requirement places too much pressure on the local fund management industry and banks, given the lack of support from foreign investors in our local bond auctions. Graph 2 below indicates the take-up of bonds issued by National Treasury in recent years.
Foreigners have not participated actively in our auctions for close to two years, after a period of averaging around 40% of auction issuance since 2012/13 and taking up more than 80% in the preceding two years. It is difficult to predict whether foreign investors will continue to shun our auctions. However, there are a few aspects that need to be considered. Firstly, real yields are substantially higher, and it is not a given that foreign buyers will stay on the sidelines given the depressed yields of developed market bonds. The most crucial variable in assessing whether the additional supply will fall fully on the local market, is whether Government will restore the credibility of our budgetary framework. Indications from the budget before COVID-19 was documented in South Africa, are that Government was committed to doing so. This notion is further supported by recent indications that the stimulus package will need to be offset with austerity measures. Secondly, we also believe Government has the option to reduce the supply of longer-dated bonds by increasing the issuance of treasury bills at significantly lower rates, where demand consistently exceeds issuance levels at the weekly auctions. Government can access this benefit due to the favourable long-term debt structure that is currently in place. Thirdly, whether through multilateral funding or additional offshore bond issuance, South Africa can access funding other than in the local markets, as noted in the release of the R500 billion stimulus package.
- Emerging market outflows should reverse when the panic subsides
Foreign flows are inherently extremely unpredictable. There is a widely held view that emerging market outflows will continue for South Africa, even in the event of an easing in global risk sentiment. It is important to assess the outflows we have already seen, as these impact valuations of our local assets. As of April 2020, foreigners have sold roughly R176 billion in government bonds since 2018. This has had a significant impact on the valuation of our local assets with the yields on our 10-year bond trading at close to 11%, our credit default swap spread now trading at 4.6% from a low of 1.6% at the end of 2019, and the rand losing the most against the US dollar in the emerging market currency basket, close to 35% down since the start of the year. In conjunction with these depressed valuations, it is important to consider some of the mitigants for South Africa relative to other emerging markets:
- South Africa has a floating rate currency which tends to react to stabilise the current account, as rand weakness translates into greater exports. Importantly, the SARB does not seek to intervene in foreign exchange markets to protect the value of the rand, increasing the value of this buffer. While the rand has weakened the most out of our peer comparisons, this is counterintuitively a potential positive as other central banks have utilised limited foreign reserves to buffer the devaluation of their currencies.
- Regulation 28 limits the offshore allocation of local funds to 30%, with a 12-month grace period to correct should this limit be exceeded. In previous periods of rand weakness, this acted as a self-correcting mechanism for the rand as capital is eventually repatriated back into the local market. We estimate that the current period of weakness could result in close to US$20 billion being repatriated over the course of the next 12 months – inevitably offering potential strength for the rand.
- South Africa’s low levels of expiring sovereign debt in 2020 and 2021 provide us with increased room to act fiscally. Further, South Africa can leverage off a strong debt structure (long dated with low foreign currency denominated debt) to issue debt that could potentially be extremely attractive to various investors with real yields close to the highest on offer globally, and well in excess of yields on developed market bonds. South Africa continues to have a deep and liquid market for investors to access and has a track record of honouring debt repayments.
How have we managed positioning?
We are continuously looking to position our funds to achieve acceptable client outcomes in the best risk-adjusted manner. A key change to our positioning has been a shift of some of the allocation from longer-dated bonds into the R186, which looks to be one of the most mispriced areas of our bonds curve. Short-term rates are currently at all-time lows with the repo rate cut to 4.25%. The R186, now being a bond with six years to maturity, is therefore more exposed to the anchoring effect of a low repo rate and also provides the benefit of an extremely steep rolldown for the remaining term of the bond, with close to 5% yield compensation above the current repo rate. Graph 3 below highlights the extreme steepness of our yield curve.
Corporate credit in light of the distress in sovereign bonds
We have been reducing corporate bond holdings in all our funds since early 2019, with our corporate bond holdings currently at long-term lows. The corporate bonds that we do hold, have also been focused on shorter-dated, floating rate bank instruments (senior, subordinated debt and negotiable certificates of deposit (NCDs)) which we believe still provide appropriate risk-adjusted returns and balance in a portfolio context. With the recent flows into income funds, the risks in this area of the market have grown due to poor pricing, poor liquidity outside of bank instruments and a weak economic backdrop. This has now been heightened by the impact of COVID-19. However, we have not yet seen the comparative price weakness we have witnessed in sovereign bonds which carry no credit risk.
When comparing the spreads corporate bonds offer in excess of those offered by the fixed-rate sovereign curve, we believe that investors are not being adequately compensated for the increased risks. Graph 4 on the following page illustrates the thin premium investors are being offered by fixed-rate corporate credit, an average spread of 0.7% above the sovereign curve, which carries no inherent credit risk.
With a deteriorating outlook, we believe that corporate credit is still in the initial stages of repricing and we are selectively looking for opportunities. On a relative basis, we continue to favour sovereign bonds in our funds.
This is an area of the market we have avoided for some time due to poor fundamentals, unsustainable dividend payouts and significant gearing. We have highlighted to clients before that we believed starting valuations, both at an underlying property valuation and a share price level, were not attractive on a risk-adjusted basis. The impact of COVID-19 has hastened the devaluation in the sector, with the index falling close to 50% for the year to date. We expect that, eventually, underlying property valuations should begin to reflect the fundamentals of increased rental pressure and normalised loan-to-value assessments. This process will highlight those that have not managed their businesses sustainably enough to survive the impact of COVID-19, but also the more resilient companies in this sector. We are confident that during this crisis, our process will identify the stand-out opportunity for clients to gain exposure to listed property.
Tough conditions signal opportunities ahead
The COVID-19 crisis has caused dislocation in prices within financial markets. In the case of domestic sovereign bonds, we view the sell-off as mostly technical in nature and believe that the opportunity has been enhanced. In fact, our fair value analysis suggests that equity-like returns could be expected from this element of our portfolios. We expect volatility to remain high given the uncertainty around the exit of the lockdown and impact on the economy and fiscus. Accordingly, we have retained cash to deploy into further weakness or into opportunities that arise within the corporate credit or property markets.
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