Investors Undeterred as South Africa Bond Inflows SoarBy
Foreigners own almost half of the country’s government debt
Credit-rating downgrade to junk could spark outflows
Political turmoil, the risk of a widening budget deficit, a weakening currency and the prospect of a credit downgrade to junk would usually put investors off a country’s bonds. Not when it comes to South Africa.
The lure of the highest yields among emerging-market peers is proving irresistible, with foreign investors buying a net 18 billion rand ($1.3 billion) of South African bonds in September, the most in a month since March. That brought inflows this year to 68 billion rand and foreign ownership of the country’s local-currency debt to about 45 percent, compared with 20 percent for Turkey and 28 percent for Russia.
“High real rates, a benign inflation outlook and scope for further easing” of monetary policy could see yields falling in several emerging markets including South Africa, Andre de Silva, head of emerging-market rates research at HSBC Holdings Plc, said in a report this week that recommended buying South African 13-year rand bonds. “We don’t see any reason to be cautious.”
The optimism may be misplaced. The ruling African National Congress is embroiled in a brutal leadership battle, while tepid economic growth means tax revenue is falling short of projections, complicating Finance Minister Malusi Gigaba’s task as he prepares to present his mid-term budget on Oct. 25. Any sign of fiscal slippage could break South Africa’s tenuous hold on an investment-grade rating for its rand debt -- and cost the country its place in indexes tracked by investors overseeing trillions of dollars.
Once that happens, many of the offshore investors holding about $45 billion of the country’s local-currency government bonds may be forced to sell. Outflows could reach as much as $14 billion, according to Bank of America Merrill Lynch. The bond market hasn’t priced in that outcome, according to Absa Bank Ltd. strategist Mike Keenan, who predicts benchmark 10-year yields could rise above 9 percent in the first half of 2018. The yield climbed two basis points to 8.64 percent by 11:17 a.m. in Johannesburg.
Moody’s Investors Service and S&P Global Ratings, which both have investment-level ratings on South Africa’s local-currency debt, are reviewing their assessments in November. With Fitch Ratings having cut its evaluation to sub-investment grade, one further reduction would dump the bonds into the junk category.
“If we are downgraded, we are likely to sell off and see outflows after the event, much like Turkey did,” Absa’s Keenan said. “There is increased country risk whether there is a downgrade or not and we believe there is scope for credit spreads to widen and core yields to move higher going into year-end.”
That isn’t the only risk. Apart from the ANC’s leadership contest, which culminates in an elective conference in December, offshore investors should also be fretting about the rand, which has dropped 3.4 percent against the dollar since June. South Africa’s currency was the worst performer among emerging-market peers in the carry trade this half, and has the highest implied volatility, suggesting traders expect price swings to widen. The rand weakened 0.4 percent to 13.6229 per dollar on Thursday.
For now, yields are high enough to compensate for the uncertainty, said Kevin Daly, a London-based emerging-market portfolio manager at Standard Life Aberdeen Plc, which oversees about $871 billion. South African 10-year bonds have the highest yield among investment-rated local-currency bonds of emerging-market nations.
“The leadership contest is a primary event and it looks like it will be a very tight vote, but there won’t be great outflows” regardless of who wins, Daly said. “We don’t think the rating agencies will be in any mood to move in November until they see what happens at the elective conference.”
While foreigners are still happy to take the yield in return for the risks, local investors are wary about the debt, according to Malcolm Charles, a portfolio manager at Investec Asset Management in Cape Town. Slowing inflation and dovish monetary policy are bond-supportive, but the key risk is the mid-term budget policy statement, he said.
“The global environment of low yields in developed nations has also been supportive but is likely to become less so going forward,” Charles said. “Local appetite is very negative with the market concerned about the budget.”