Opportunities exist in the turbulent bond market

Adriaan Pask

Local bonds are generating equity-like returns, creating an opportunity for investors

According to the latest medium-term budget, South Africa's debt-to-GDP ratio will rise to 77% over the next few years, up from the current figure of 72%. Against this backdrop the Reserve Bank has increased interest rates 10 times since 2021, in order to bring inflation under control, with the repo rate now sitting at 8.25%.

These factors, combined with withering investor confidence in the state of government finances, have had a profound impact on the South African bond market, with 10-year yields touching 11.5% in October 2023.

This return is more like what one would expect from equities – quite a departure from bonds being a somewhat notoriously boring space of the market.

Bond yields in the US have also been under pressure over the last year, driven in turn by concerns around inflation. This was brought about by ultra-low Covid era interest rates, which ultimately had to normalise, resulting in pain for bond investors over the last 18 months.

US bonds, as is the case with South African bonds, also reflect fiscal risk. Covid spending led to much higher debt-to-GDP levels in most countries around the globe and policymakers now need to focus on how to reduce debt-to-GDP ratios. Roughly half the US government debt is also maturing or being called up over the next four years. So, unless US policy makers get rates materially lower, that debt will have to be refinanced at much higher yields. This is a cause for concern and is reflected in the downgrade of US treasuries by rating agency Fitch in August 2023, with Moody’s changing their outlook on US Treasuries to “negative” as well in November 2023.

We are also seeing China, historically a key buyer and holder of US bills, starting to offload and pivoting into other asset classes. These issues are all warning signs for the US bond market and are ultimately reflected in current US bond yields.

There is an argument that as long as the debt is being used for growth, you can essentially grow yourself out of your debt problem. The risk is, however, that the cost of that debt becomes so high that, even if growth is strong, it is still insufficient to offset the debt servicing costs.

Looking ahead, US inflation levels remain a key data point for bond investors. While there is a view that inflation in the US is under control, core inflation is still a cause for concern as it remains sticky at 4%. There is also early evidence of stresses in the US economy because of the high interest rate environment. We are already seeing escalating bankruptcies, which speaks to the fact that finance costs on debt for corporates are getting to a point that is unsustainable. The reality is that if you see bankruptcies, naturally you start to see unemployment.

It will be very difficult for the FOMC [Federal Open Market Committee] to justify lowering rates again to save the economy, as they did during Covid. Inflation is still not under control, and lowering rates prematurely might, down the line, unleash the inflation genie out of the bottle again, undoing the effort of the last 18 months.

In South Africa's case, we sit with a strong and persistent primary deficit, and it doesn't look like commodity prices are going to save the day any time soon. The issues at our SOEs (state-owned enterprises), which have required enormous bailouts over the last two decades, are not being resolved, and new issues keep surfacing. It is also important to remember that these bailouts have been, and will continue to be, funded by debt. This fundamentally undermines South Africa’s economic growth.

However, while it's discouraging to see that our bonds are being punished to reflect the risks, the current environment has given rise to opportunities. A mid-term SA bond is trading at a yield of roughly 11% and inflation is approximately 4.5%. This generates a real return of a 6.5%.

Our expected long-term real return from bonds is inflation-plus 2.5%, while our expected long-term return from equities is inflation-plus 7%. In other words, our bond market is generating equity-like returns at the moment. This does not take into account the potential upside of a capital gain on these bonds as interest rates come down in South Africa.

In our view it is worth investors considering whether these higher yields and risk premiums are warranted, and whether it is worth including these assets in their portfolios. We do however strongly recommend that people obtain advice from an accredited financial adviser before making any decisions in this regard.