South African Bonds Offer World-Beating Gains. Citadel Wants Out

  • Debt has returned more than double next contender this quarter
  • South African political risks and Fed hike could scupper party

George Herman at Cape Town-based Citadel Investment Services is dumping the emerging world’s best-performing bonds.

South African government rand notes have earned 14.3 percent this quarter in dollar terms, the most out of 31 developing nations tracked by Bloomberg indexes and more than twice the return of second-placed South Korea. Yet Herman, 49, says the move has gone too far. He’s selling all his holdings in favor of shorter-dated securities.

Investors chasing returns as developed nations maintain economic stimulus may be underestimating South Africa’s domestic risks and the willingness of the U.S. Federal Reserve to increase interest rates, said Herman, whose Citadel SA Protected Equity H4 Fund has outperformed about 80 percent of its peers this year, according to data compiled by Bloomberg. 

The threat of a South African debt downgrade and a call by the ruling African National Congress to “re-prioritize” the budget as it tries to win back support after a drubbing in municipal elections are also warning signs, he said.

“That worries me a lot,” said Herman, head of South African portfolios and asset allocation at Citadel, which oversees about 44 billion rand ($3.3 billion). “Re-prioritize is fancy-speak for tear up. That will catch the attention of rating agencies.”

Finance Minister Pravin Gordhan staved off a credit downgrade in June by convincing rating companies that he would stick to fiscal targets. Gordhan is delivering his mid-term budget update in October, two months before S&P Global Ratings reviews the country’s status, on which it has a negative outlook. S&P and Fitch Ratings Ltd. both rank the debt at the lowest investment-grade level.

Populist Policies

The ANC said at the weekend it will press the government to re-prioritize the budget to deal with joblessness, poverty and inequality. It also mandated the government to speed the process of implementing a national minimum wage in what some analysts see as a bend towards “fiscal populism.” Fitch warned that the drop in support for the ANC increased the risk of more populist government policies that require breaching expenditure ceilings or undermining economic growth.

Not all investors agree. Should South Africa pass the rating hurdle in December, yields on benchmark 10-year bonds may ease back to about 8 percent, according to Gryphon Asset Management. Yields on the notes fell four basis points to 8.41 percent on Thursday, extending the decline since the end of June to 43 basis points.

“I don’t expect the credit downgrade is going to happen anymore,” said Abri du Plessis, a money manager at Cape Town-based Gryphon, which oversees about $250 million. “If we can pass that point, we can probably break below the 8 percent level. In the meantime, at current levels I definitely see value.”

Under Threat

Foreign inflows to South Africa’s bond market are also under threat from the possibility of a U.S. increase in borrowing costs this year. Comments from New York Fed President William Dudley and Atlanta Fed chief Dennis Lockhart on Tuesday raised the probability of a Fed hike this year to above 50 percent for the first time since the U.K. voted to quit the European Union on June 23.

For Investec Asset Management’s Malcolm Charles, who helps manage about $116 billion and has started trimming back on his overweight position in South African bonds, valuations have run ahead of macroeconomic fundamentals. 

‘Pretty Cautious’

With inflation still above the central bank’s 3 percent to 6 percent target range and growth forecast at zero percent this year, “this is a time to be pretty cautious,” Charles said from Cape Town. “If we were confident that policy was going to improve, inflation was going to come down faster than the Reserve Bank currently thinks, absolutely then we would look to buy back. We need the ratings agencies to give us another stay of execution in three months’ time.”

For Citadel’s Herman, the risks are too high. Citadel was market-weight in bonds mid-year, and has been selling since then. They’ll all be gone by January, he said.

“The moment the Fed steps on their trigger then everybody’s going to be caught with their pants down in this little bond party that we have right now,” Herman said. “That would be an ugly, ugly environment.” 

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