• Over recent weeks, government struggled to find demand for some of its bonds.
  • This was due to an unexpected surge in US bond yields, leaving other bonds looking less appealing.
  • But fund managers are not that concerned. They believe that SA bonds are well placed - despite government's large debt burden.
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Over recent weeks, the South African government struggled to find demand for some of its bonds, forcing it to pay much higher interest for badly-needed money.

On the face of it, this is unsettling: paying more for money raised via bonds will leave less to pay for salaries and other services.

Bonds are basically IOUs, which pay regular interest payments, with the full amount paid back after some years. Government issues new bonds and then auction them off. Given the solid interest rates it offers on these bonds, there are usually more bids than bonds available at these weekly auctions.

But since the end of February, demand for some of the bonds has tanked.

At an auction in mid-March, government sold less than R1.7 billion of the R2 billion in inflation-linked bonds on offer. By last week, this fell to less than R1.3 billion out of R2 billion available.

What’s is going on?

American bonds have been exploding

For a long time, the yield on US government bonds – which is effectively seen as a “risk-free” rate, the anchor for most global interest rates - has been far below 1%. This has dramatically increased since the beginning of February 2021.

Yields have exploded as the US embarked on an eye-watering $1.9 trillion Covid-19 relief package. The US will be taking on much more debt to fund it, and the package – which includes payouts to millions of people – will flood that country with cash, triggering inflation. Both developments are poison to bonds. This week the yield on the US 10-year bond hit its highest level in 14 months, at almost 1.8%.

Suddenly, South Africa’s government bonds yields weren’t looking that wildly appealing by comparison.

There are concerns about how many more bonds Treasury want to issue

There was some uncertainty about Treasury’s debt management strategy post the February budget and how much it would reduce it weekly issuance programme by, says Nishan Maharaj, head of fixed interest investment at Coronation Fund Managers. This, combined with the sell-off in global rates, dampened demand.

Last year, when there was a big demand for South Africa’s high-yield bonds, Treasury went all out in issuing bonds and raised billions. Also, there were large, surprise windfalls in mining royalties and corporate tax which it didn’t expect. In the end, despite a crippling lockdown, and bans on cigarette and booze sales, South African tax income for the past year looked almost R100 billion better than expected; it was down “only” 10.6% from pre-pandemic 2019, Treasury reported in the national budget.

But for weeks after the budget, there was uncertainty around the volume and tenor of bonds that Treasury were going to issue.

Finally, Treasury gave some certainty last week, and substantially lowered the number of bonds it will auction. This gave some comfort to investors and boosting confidence, says Maharaj.

Zain Wilson, a portfolio manager at Old Mutual Investment Group, says Treasury may “surprise to the upside”, with even less reliance on auctions in the future that is currently expected.

Wilson says the budget has brought a meaningful change, when government’s income exceeded the “admittedly low hurdle” which was set earlier.

“With growth due to be improve off a low base in 2021, and Treasury holding the line on the expenditure ceiling, the ‘risk’ over 2021 is better revenue delivery (via improved tax performance), and thus a lower than targeted deficit and bond issuance.”

SA bonds may not face that much pressure from the US

Will government be forced to pay higher interest rates in future on its bonds due to the spike in US rates?

This would be exceedingly bad news. South Africa’s debt has ballooned during the pandemic, with gross borrowing increased from R433 billion to R670 billion.

A fifth of all tax income is now paid to its creditors, with debt service costs reaching R233 billion over the past year. If government were forced to pay higher interest rates on new bonds, this would add billions to repayments.

But Maharaj does not expect that the US government bond yields will experience a similar magnitude of sell-off seen since the beginning of the year over the near term, and believes that the market has already priced in an adequate US inflation expectation.

Also, emerging markets – including South Africa – are in a different position than during the last US bond market spike, the so-called “taper tantrum” in 2013. Then, South Africa and others were running large current account deficits. Now, South Africa has a current account surplus – thanks to much stronger exports – and not that reliant on foreign capital to stay afloat.

“South Africa is still in a precarious debt position – but the latest budget [which showed a stronger-than-expected fiscal position], provides us with a stronger starting point and hence a bit more time to turn the ship around.”

In addition, South Africa is also less dependent on foreign bond investors – who now represent less than 30% of South African bond holdings, compared to above 50% in 2013. Foreign selling won’t move the market to the same extent now.

Also, Wilson says, historically, when the world exits a recession, US bond yields start to rise, but higher-yielding bond yields (like those in SA and other emerging markets) tend to fall.

“We expect a similar pattern to unfold over the coming year. While US bond yields have risen as one would expect coming out of a recession, improving growth conditions should reduce the additional yield investors demand in higher yielding bonds.

“As long as rising US yields are of the ‘growth friendly’ kind, and don’t reflect a policy error of the United States Federal Reserve tightening too soon, we do not think this will be a headwind to South African bonds, but rather expect the yield gap to close – reflecting improving global growth.”

Some foreigners still love SA bonds

While the Treasury auctions have sometimes struggled to sell all SA bonds on offer, there still seems to be some appetite, with foreigners buying R1 billion more in SA bonds than they sold last week, according to the latest JSE statistics.

Still, since the start of 2020, they have been the net sellers of around R80 billion in South African bonds, mostly due to South Africa’s loss of its investment grade.

“This light positioning, alongside our expectations of global liquidity to remain abundant, central bank policy to remain easy, and yields to remain low (not withstanding the recent rise) should support foreign buying of South African bonds this year,” says Wilson.

“This creates a positive tailwind for potential foreign buying, particularly as South African bond yields continue to look extremely attractive from a global investors perspective.”

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