When Nhlanhla Nene was dismissed as finance minister in December 2015, the markets took it very badly. Yields on 10-year government bonds blew out to 10.5% at their peak.
In the midst of that crisis, few people saw this as a buying opportunity. Hardly anyone wanted to touch South African government paper because it was seen as too risky.
In hindsight, however, this was the best investment opportunity South African investors had seen for some time. Local bonds were the best-performing asset class in 2016, delivering a return of 15.5%.
Following the dismissal of Pravin Gordhan and the ratings downgrade from S&P, it may seem that we are in an environment that is fairly similar. Yields on 10-year bonds have risen nearly one percentage point from mid-March to current levels around 9%.
Although it might seem a rash question given the current state of South African politics, is this buying territory?
“I think the risk with this kind of environment is you easily get sucked in and miss an opportunity, which is why I think this is a good question,” says Zain Wilson, an analyst at Old Mutual’s MacroSolutions boutique. “I’m not sure portfolio managers acted quickly enough during Nenegate. In retrospect, you should have bought 5% to 10% of your portfolio in bonds and it would have been a great trade.”
The head of fixed interest at Sanlam Investment Management (SIM), Mokgatla Madisha, however, feels that while the two environments are similar, they are not the same. “The market was a lot better prepared this time around,” he says. “We were already priced for a downgrade, which is why the reaction was much more muted.”
Although the downgrade was eventually precipitated by the changes to cabinet, many analysts had been expecting it to come for some time.
“Secondly, commodity prices are very supportive of the rand at the moment,” Madisha adds. “In 2015 and the beginning of 2016 commodities were falling out of bed, but this time around our terms of trade are significantly stronger and so fundamental support for the rand is there.”
What is certainly noteworthy is that foreigners have been significant net buyers of South African bonds in recent days. Clearly, they believe that the yield that they are receiving for the level of risk they are taking is disproportionately high.
However, Wilson says it is an opportunity that you should approach with your eyes wide open. Analysis done by MacroSolutions suggests that markets tend to act fairly consistently at the point of a downgrade, with bond yields rising and the currency weakening.
However, what happens after that depends on whether the country suffers multiple downgrades or not.
“In Greece, for instance, yields kept on going for another year and a half,” Wilson says. “But in places like Russia and Brazil, the date of the downgrade was the opportune time to buy because things stabilised after that.”
Investors therefore need to consider to what extent they think there is a risk of South Africa seeing multiple downgrades. And this is very dependent on politics.
“Politics is not like economics where you have hard data that you can look at and have a fair amount of conviction,” says Wilson. “There is a lot of uncertainty and your sources give you various scenarios which may or may not play out.”
This means that you have to be very astute in your risk management.
“Our conclusion is that South African bonds offer value at these levels, but the question is not whether or not you should be buying, but how much you should have,” says Wilson. “Having a huge amount in your portfolio given the current environment doesn’t make sense because you are taking an inordinate amount of risk.”
SIM’s Madisha, is even more cautious. He argues that it’s too early to tell whether bonds now present a buying opportunity.
“I think a lot will depend on the rand,” he says. “If it stays within deflationary territory – in other words, firmer than last year’s average level of R14.40 to the dollar – the outlook for inflation will stay reasonably supportive and you can say bonds offer reasonable value at these levels. That’s because inflation will be heading towards 5.5% for this year and then the real yield you are getting on bonds is attractive.”
However, if the rand falls beyond that mark, the risk of higher inflation and even higher interest rates come into play.
“The South African Reserve Bank has said that the downgrade has set us back,” Madisha says. “The politics are such that you could end up with the currency losing support and they might even have to hike rates, whereas a few weeks ago we would have said that the next move was going to be down.”
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