Amid heightened political intrigue around the Zuma administration and in the wake of credit rating downgrades to junk status by both Standard and Poor’s (S&P) and Fitch, as well as the recent downgrade by Moody’s local investors have grown increasingly wary of South African government bonds.
As a result, these bonds are now offering attractive real yields. Should you be taking advantage of these yields or are the risks too great?
Investment decisions based on predictions are flawed
One of the key concerns around South African government bonds is the risk of a downgrade of our rand-denominated debt to junk status. To date, only Fitch has downgraded South Africa’s local currency debt rating to junk. A similar downgrade by one or both of the remaining agencies has the potential to see South Africa ejected from global bond indices.
While we are cognisant of this risk, we do not believe that the possibility of a further downgrade is sufficient justification to leave South African government bonds out of our portfolios. Building portfolios around a prediction or a narrative tends to result in more binary potential outcomes. Simply put, portfolios are skewed towards a particular outcome with the belief that markets will react to this outcome in a certain way. It is very hard to get both the event and the resulting outcome right, especially on a consistent basis. The probabilities just don’t stack up. Even with a very respectable hit rate of 70% in both areas (accurately forecasting market events and correctly extrapolating their impact), statistically, your probability of success is only 49%.
Potential implications of a downgrade
If we consider South Africa’s credit default swap spread (effectively, the cost of insuring against the South African government) in the context of other countries that already have junk-status ratings (such as Brazil, Russia and Turkey), we find that the market has already priced in a downgrade. While we would expect some volatility in bond prices if the downgrade happens, the medium-term price impact could be minimal.
However, the potential upside if the reverse happens is an important consideration. If local government bonds were to enter a bull market to the extent that they match their lowest yields since the introduction of inflation targeting, there are total return opportunities of 20% and 30% on 10-year and 20-year bonds respectively. We do not believe that it is rational to have no exposure to an instrument with a very bad scenario priced in and a favourable outcome seemingly completely ignored.
What are the facts on hand?
When buying SA bonds, you are lending money to a democratic republic, not to a president or political party
South Africa remains a functioning democracy. In fact, this has been tested over the last number of years. Consider the handover of power in key municipalities, the independence of our judiciary and the freedom to mobilise in mass against the president.
South Africa is wisely funded
The country’s public debt is well structured, both in terms of currency and maturity. 90% of outstanding debt is denominated in local currency and the weighted average term to maturity is 15 years out.
South Africa remains well funded
South Africa’s metrics fare well when compared to other emerging markets and developed economies – yet our credit risk has been priced similarly to our peers. South Africa’s debt as a percentage of GDP is 43.3%, compared to 75.4% in Brazil, 32.7% in Turkey and 13.7% in Russia. In Japan, the ratio rises to 234.7%, while the US, France and Australia have debt/GDP ratios of 73.8%, 96.0% and 46.1% respectively. Similarly, South Africa’s budget deficit as a percentage of GDP is -4.1%, while Brazil’s is -9.0%, Turkey’s is -1.2% and Russia’s is -3.9%. Japan (-5.7%), the US (-3.1%), France (-3.4%) and Australia (-1.5%) also have ratios within this range. Clearly, South Africa is not an outlier.
Credit risk is not the only risk to consider
Avoiding credit risk by investing solely in cash may offer a false sense of security. The most obvious risk is that of getting the call wrong and failing to capitalise on a bond market rally. While waiting for a possible downgrade (which may or may not happen and cannot be accurately timed), you also sacrifice cash-beating returns. Finally, if you time the interest rate cycle incorrectly, shorter-dated instruments will earn progressively lower yields upon renewal (this is called reinvestment risk). By investing in longer-dated instruments, you are not building such a tremendously binary portfolio and at least partially lock in higher potential returns.
Our bond holdings are moderate and our portfolios diversified
We manage correlations within our portfolios and diversify across industries, geographies and the yield curve – always ensuring inherent quality and a sufficient margin of safety in all the instruments we buy. Within this broad mix, South African government bonds currently comprise 9% of the PSG Balanced Fund and 14% of both the PSG Stable Fund and the PSG Diversified Income Fund.