MACROSOLUTIONS
WHAT ARE BOND YIELDS TELLING US:
SAFE HAVEN OR HEALTH HAZARD?
ZAIN WILSON
INVESTMENT ANALYST
MAY 2016
South African bond managers agree that the single most important
10-YEAR AVERAGE INFLATION IS THE BEST PREDICTOR OF SOUTH
driver of bond yields is the market’s view of long-term inflation.
AFRICAN BOND YIELDS
Peering into the inflation looking glass alone would explain the level
(June 1980 - April 2016)
25%
of our 10-year bond yields more than 80% of the time since the early
the result of a global bond-friendly cocktail that started 30 years ago:
the use of floating exchange rates post the Bretton Woods pegged
system, greater monetary policy independence between states, and
the spread of central banks worldwide adopting inflation-targeting
regimes.
SA 10-year bond yield
1980s! This is not a uniquely South African phenomenon, but rather
20%
15%
10%
A STRONG BOND WITH INFLATION
What is perhaps more surprising is that this relationship between
bond yields and long-term inflation has historically held stronger for
South African bonds than some of our more prominent developed
market peers − a show of faith from the bond market in the credibility
of the South African Reserve Bank (SARB). This has been in an era
where we have seen inflation targeting greatly reduce local inflation
volatility. This has made it easier to know where to look, and has
also removed much of the fog – making life much less complicated
5%
5%
7%
9%
11%
13%
15%
17%
SA 10-year average inflation
Sources: MacroSolutions, FactSet
THE MARKET’S GAZE HAS SHIFTED
Of course, anyone who has kept an eye on local bond yields over
the past six months, will tell you that while this relationship holds true
for a South African bond manager!
in the long run, it has not helped South African bond managers of
TRUSTING SARB: SA BONDS EXHIBIT A STRONGER RELATIONSHIP
our Finance Minister in December last year a one-in-20-years event,
WITH LONG-TERM INFLATION THAN DEVELOPED MARKET PEERS
(*June 1980 – April 2016)
86%
83%
79%
79%
late. Not only was the spike in yields following the replacement of
but there has also been a steep increase in the volatility of local
bonds. While a rising inflation profile hasn’t helped, the SARB’s
credibility remains intact. Instead, the market has shifted its gaze to
a worsening political environment and a likely ratings downgrade to
”junk” status by either or both Moody’s and Standard & Poor’s sometime
this year. The market is fickle and periods of sovereign distress quickly
shift the focus away from an inflation-predicting game to one of debt
sustainability and the bond owner’s ability to recoup the real value
57%
of their investment.
How we got here…
Germany
United Kingdom
Japan
South Africa
United States
Strength of Relationship
While the adjustment in yields has been sharp, the reasons for it have
played out gradually since the 2008 Global Financial Crisis. Part of
Sources: MacroSolutions, FactSet
* 1980 was the peak of the US Inflation cycle, when US Fed Chairman Paul Volcker aggressively hiked US interest
rates over 15% during the preceding four years. This was in an attempt to bring under control the high levels of
inflation that had plagued the US and the world for the prior two decades; and was a watershed moment for
central bank credibility in targeting inflation.
this is a slowdown in growth − a function of our vulnerability as a
small, open economy and our linkages to China as it transitions to a
spread of 390 basis points being higher than those of all but four of
new growth model. This has been further compounded by an extended
our peers in the sub-investment grade basket. While this does not
period of fiscal slippage, a culture of household dissaving, and a
mean bond yields cannot or will not go higher, it is worth noting that
lack of private sector investment − leaving the economy running with
of the group of four, three (Greece, Egypt and Pakistan) are currently
increasingly large ”twin deficits” (current account and fiscal deficits)
operating under debt relief programmes, and the fourth (Brazil) is in
alongside the stalling growth engine. Without local household and
the midst of both its deepest recession in over 35 years and a forced
private sector savings, a large portion of our bonds, while denominated
political regime change.
in rands, has been financed by foreign capital. This exacerbates the
effect of downgrade fears on bond prices, as foreign holders of South
African bonds do not view SA risks through the lens of Government’s
DOWNGRADE IS ALREADY IN THE PRICE
S&P currency ratings versus CDS spreads
1000
ability and willingness to repay their rand debt, but rather focus on
Investment Grade
doing so would run the risk of fuelling inflation and placing the currency
under further pressure.
While investors’ paradigm shift from viewing our bonds as ”attractive
yield” to ”junk” was sudden, the “South Africa suffers” story has played
out as a long running one in our currency. This is evident when viewing
the rand’s sustained grind weaker against a basket of our emerging
market peers, suggesting the adjustment of our bond yields higher in
November can, to some extent, be viewed as bonds catching up to
700
Brazil
(December 2005 - May 2016)
500
SA Suffers
4%
200
3%
150
2%
100
1%
50
0%
SA Surprises
2009
2010
Russia
Turkey
300
Mexico Peru
Colombia
Malaysia Saudi Arabia
Thailand
Abu Dhabi Qatar
Sweden
China
Philippines
Italy
Denmark
Israel
Chile
Hong Kong Netherlands
Poland Spain
South Korea
Australia New Zealand
100
France
Ireland
Switzerland
Japan
Finland Belgium
Czech
United Kingdom Norway
Austria
Germany
United States Republic
0
AAA
AA+
AA
AAA+
A
ABBB+ BBB BBB200
Croatia
Portugal
Vietnam
Indonesia
Hungary
Romania
BB+
BB BB- B-
S&P local currency ratings
ALL IS NOT LOST
As long as the SARB maintains credibility as an inflation-targeting
2011
2012
2013
2014
2015
protect investors’ claims against the South African government in the
SA 10-year bonds minus EM bonds
SA rand vs MSCI EM Index (indexed)
5%
2008
R² = 0.7814
South Africa
400
central bank and our legal and institutional frameworks continue to
250
2007
Egypt
Sources: MacroSolutions, FactSet
SOUTH AFRICAN BONDS "CATCH UP" TO THE RAND
South African rand and bonds versus emerging market peer group
2006
Pakistan
600
foreign investor sentiment displayed in the currency.
0
2005
Sub-investment Grade
800
10-year CDS spreads
despite the SARB’s ability to print currency to meet their debt obligations,
Greece
900
what the investor’s US dollar, euro or yen returns will be. Furthermore,
-1%
Sources: MacroSolutions, FactSet
event of a “default”, rand-denominated bonds at current prices offer
good rand returns in a low-growth world. This is particularly true when
considering that just as long-term inflation is the best indicator of
starting bond yields, starting bond yields are the best determinant of
long-term bond returns − in the absence of any defaults or restructuring
(à la Greece).
However, short-term returns are far less predictable and the roadmap
to unlocking value will be determined by a number of factors. These
include unforecastable risks around a possible downgrade and
political noise, as well as, over the medium term, Government’s ability
How much worse can it get?
to enact the necessary policy changes that will resolve the structural
When sovereign and ratings risk are driving bond yields, to better
issues identified earlier: increasing fiscal flexibility, re-engaging the
understand how much worse it can get if we get downgraded, one
private sector to kick-start growth, and improving the savings culture
place to look is the credit default swap (CDS) market. CDSs can be
of households.
thought of as the cost of insurance: how much investors are willing
to pay to protect themselves from the rising (or falling) risk of default.
The higher the CDS spread, the higher the insurance premium as the
issuer’s default risk increases, and vice versa. Looking at South African
CDS spreads against a broad basket of peers, it appears that much
of the downgrade risk is already priced in. This is evident in our CDS
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May 2016