Business Day

At the belly of the curve

With election season upon us and heightened levels of policy uncertaint­y, including the National Health Insurance Act, a question is always posed around the investment case for SA. The single biggest asset class locally is government bonds, hence we find this as an appropriat­e benchmark to sense our attractive­ness for portfolio managers internatio­nally.

There has been some criticism on the risk/return behaviour of local fixed-income securities, with some investment profession­als viewing them as quasi-equity. This is particular­ly as we have experience­d multiple credit ratings downgrades into subinvestm­ent grade by all three major global credit ratings agencies — S&P, Moody’s and Fitch — over the past five years. Furthermor­e, we remain greylisted by the Financial Action Task Force, which has added pressure to our relative attractive­ness.

Consequent­ly, we have seen foreign investors reducing their holdings of local government bonds, from close to 40% to under 25% now.

The largest threat to the local fixed-income security market is fiscal consolidat­ion. Recently, the Reserve Bank tapped into the gold and foreign currency reserves to plug the hole created by increasing debt and debt servicing costs. This was seen as a slight positive from markets, with bond yields marginally compressin­g after the announceme­nt. However, overall we have seen a general slip in local fixed-income securities, with some of the underlying factors around fiscal consolidat­ion remaining a concern.

We continue to run a fiscal deficit on a consolidat­ed basis including debt servicing costs, which means we are spending more than we earn. Stateowned enterprise­s continue to pose a challenge, often struggling to be self-sufficient and requiring capital injections from the government periodical­ly.

Capital allocation is an issue, with the government spending more than 35% of its budget on wages and only about 10% on economic developmen­t. Furthermor­e, the fastest-growing expenditur­e item continues to be debt servicing, despite the Bank tapping into its reserves.

Meanwhile, our economy is expected to expand below full its potential with a persistent negative output gap. This implies that tax revenue will continue to be under pressure.

From a return perspectiv­e, local fixed-income securities have not shielded investment portfolios from the volatility over the past couple of years, which supports the assertion of local government bonds behaving like quasi-equity.

Notwithsta­nding these risks, we continue to find local fixedincom­e securities attractive from an investment perspectiv­e.

We find most of the abovementi­oned risks priced into local government bonds. Inflation differenti­als have stabilised, and though inflation is above the Reserve Bank monetary policy committee’s midpoint target of 4.5%, we have seen local inflation and inflation expectatio­ns within the upper-bound target of 6% for a sustained period.

There has been some strengthen­ing of the rand over the past couple of weeks and the currency has the potential to advance further over the next couple of months as monetary policy begins to normalise across the globe and we begin to see some risk-on sentiment. However, further out we do anticipate moderate rand weakness due to some of the above structural issues.

On the credit front, government debt-to-GDP remains well below what was projected during the Covid-19 pandemic, and the credit default spread on government bonds remains a healthy and attractive one from an investment perspectiv­e.

Most of what has driven local government bond yields higher has mainly been around global factors, including geopolitic­al tensions, elevated global inflation and a tight monetary policy regime across the board. Similarly, we have seen government bond yields in the US, UK and Europe slip aggressive­ly, making them among the worst-performing asset classes over the past five years.

Fixed-income securities across the globe could not provide the required diversific­ation benefit from equity markets because the root cause of market drawdowns was rising interest rates themselves. However, when starting from a high-rate environmen­t, they tend to provide that exact benefit.

Though we do not know when interest rates will start going down, we expect rates over the next three to five years to be lower than current levels. We also expect the duration spread between the benchmark 10-year government bond yield and three-month treasuries to be lower, indicating better economic prospects ahead.

Within our multi-asset portfolios, we have a sufficient allocation to local fixed-income securities due to an above-inflation real yield to maturity, room for yield compressio­n and capital appreciati­on, attractive coupon rates and the expectatio­n of an alternativ­e systematic risk to equity markets — allowing for diversific­ation.

Within this asset class, we advocate a duration-neutral strategy, at the belly of the curve, to benefit from coupon reinvestme­nts should bond yields slip.

NOTWITHSTA­NDING THE RISKS, LOCAL FIXED-INCOME SECURITIES ARE AN ATTRACTIVE INVESTMENT