Moody's is expected to finally strip South Africa of its investment-grade rating on Friday. (Getty)
  • The yields on South African 10-year bonds have spiked to above 12% - and there's now a record-large gap between SA and US yields.
  • This is bad news for government's finances, as bond yields guide the interest rates that the state pays on borrowed money.
  • But the spike may subside as global investors start looking for attractive yields.
  • Amid the current market mayhem, this week's expected Moody's downgrade may not have a big impact.
  • For more stories, go to Business Insider's home page.

The yield on the 10-year South African government bonds has spiked to above 12% on Monday. This is not a good thing.

Source: Bloomberg/Johann Biermann

Bond yields are important because they guide the interest rates the government ends up paying to borrow money.

If bonds yields are high, government will have to borrow money at higher interest rates. The state will have to pay billions more in interest to pay for local roads, hospitals, and services.

As recently as last year, yields were trading around 8%. This means that if government had to issue new bonds today, it will have to offer interest rates that may be up to 50% more (from 8% to 12%).

The spike in South African bond yields reflects massive global uncertainty, with investors dumping everything perceived as risky, says Izak Odendaal, investment strategist at Old Mutual Multi-Managers.

Over the past two weeks there has been a meltdown on global market as economies shut down amid the coronavirus crisis.

Odendaal says that other emerging market commodity producers have seen their bond yields rise by a similar magnitude. “The difference is that their starting point is lower. Because of worries around our fiscal situation and the risk of a Moody’s downgrade, our bond yields never declined in line with our peer group in 2019.”

Moody’s is expected to finally announce that South African government bonds will lose their investment grade rating on Friday. This means our bonds will be "junk", and will be kicked out of a key international index of bonds. Some international funds are not allowed to invest in junk bonds, and is expected to trigger sales of SA bonds.

This fear has pushed South African yields higher for many months.

It's ironic that everyone was worrying about Moody’s, and along comes Covid-19, completely overwhelming any potential impact of a downgrade, says Odendaal.

He now does not expect that the downgrade will by itself have a big impact. South African bonds are already very cheap, and trade at higher levels than other countries with worse credit ratings.

High yields and government finances

If the spike in yields is temporary, the impact on government finances should be limited.

“The bigger worry is of a sustained global economic downturn, which would hurt government tax revenues (which were already under pressure), while measures aimed at curbing the spread of Covid-19 could lead to increased spending. Wider deficits and additional borrowing are a realistic risk. But this will be true of most governments around the world,” says Odendaal.

Odendaal says that following the coronavirus market crash, South African government bonds should benefit as global investors search for attractive interest rates.

“I think once the dust settles investors will realise two things: One, global interest rates are going to be stuck at zero for an extended period, and yield will be in short supply. Two, local inflation is going to face further downward pressure (especially now with the lower oil price) and therefore the potential real returns from local government bonds is substantial.”

South African bonds are offering a much higher interest rate than any bonds offered by richer countries.

The gap between SA and US bonds is at a record high:
Source: Afrifocus Securities

“Either our bonds are very cheap right now or US is very expensive,” says AfriFocus Securities.

In many rich countries – including Germany, the Netherlands, Japan and France – governments are paying negative interest rates: lenders are paying these governments for the privilege to lend to them.

“The world is highly unpredictable, and we cannot know when foreign selling of SA assets will stop, nor how much economic damage we will end up inflicting on ourselves. However, what we do know is that common sense will once again prevail at some point. When that point comes, domestic bonds are currently the most oversold in history,” says Nolan Wapenaar, Chief Investment Officer at Anchor Capital.

Read: These SA unit trusts have lost the most money

Also, the expected Moody’s downgrade may even work in South Africa’s favour, says Schalk Louw, a portfolio manager at PSG Wealth. While South Africa is now the most risky government bond in the investment grade club, it will be among the most exemplary in the junk category. When international investors start looking for yield again, they will start in the junk group, which offer the best interest rates. And in this group, South Africa is among the safest options.

This is because the majority of South Africa’s government bond debt is in rand – not dollar. So even given the rand’s recent slump (from below R15/$ a month ago to near R17.66 currently), this won’t threaten its ability to settle its debt. Many other emerging markets are not in the same position, which was the reason emerging bonds were hit by a sell-off of 20% this month, says Louw.

Should you invest in bonds?

Investing in South African government bonds may be something some local investors should start to consider, says Louw.

“It is starting to look attractive – especially as the stock market remains in turmoil.”

His preferred investment options would be either RSA Retail Bonds, which currently offer 8% a year (or you can choose to receive 3.75% plus the inflation rate) over five years, or unit trusts that invest in bonds.

These bond funds have been outperforming money market funds: In the year to end-February, the benchmark return for local bond funds was 8.9% - compared to the money market benchmark of around 7%.

What are government bonds?
A bond is like an IOU, with the borrower agreeing to repay an amount plus interest.Countries issue government bonds, which promise to repay an amount at a fixed rate of interest at a specific time. The 10-year government bond, for example, will be repaid in 10 years.After a government issued the bonds, they are bought and sold by investors to other investors in the market.

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