SA bond market could fall further

Said Jean-Pierre du Plessis, Fixed Interest Strategist at Prescient Investment Management: "There is the potential for further losses in the South African bond market. Given that foreigners own about 35% of our market, we are heavily reliant on international capital flows.

"There’s been the sell-off seen in the bond market where the risks Prescient highlighted previously are still playing out. The short end of the interest rate curve has moved as well, and several rate hikes are now being priced in.”

Yields on SA bonds have risen in line with accelerating inflation, which recently breached the upper end of the central bank’s target for the first time on over a year. And given currency weakness, petrol price hikes and wage adjustments, risks to inflation are on the upside.

However, du Plessis added that if bonds continue to sell-off they will start to become more attractive.

Looking at the international backdrop, he said the world had been living in extraordinary times in recent years with extremely low bond yields in the US and Europe. An environment of more positive economic growth could result in higher rates, heralding a period of "rate normalisation” and resulting in more positive bond rates globally.

Global trends will have a major impact on the SA bond market.

"Rate normalisation could have a massive impact on our bond market in terms of directing investments away. However, as real rates increase, local investors will increase allocations to bonds, which will have implications for other assets,” said du Plessis.

He added that, in terms of interest rate policy, it is unlikely the SA Reserve Bank will increase rates in the short-term given that economic growth is the priority. "The temptation is to raise rates to shore up the currency and attract investment, but we couldn’t do that without compromising already anaemic growth.”

Another factor is SA’s weaker credit rating, which means that the premium required to own SA bonds has gone up. This is in recognition of the additional risk involved in owning SA bonds.

Current account deficits, that indicate the country is living beyond its means, are being funded by portfolio flows and are putting the rand under pressure, which in turn, raises the risk of ratings agencies downgrading South African markets and the economy.

Said du Plessis: "The implications of downgrades, in addition to denting investor confidence, are that we run the risk of being removed from world bond indices if we fall too far down the ratings spectrum. This would destabilise the market.”

He added that, globally, central banks continue to affect the market by buying up bonds in developed markets to influence investment in higher risk assets like equities, and to stimulate the economy.

"Their policy of quantitative easing is keeping global interest rates low and while the SA Reserve Bank has not had to interfere through quantitative easing, our highly liquid bond market has benefitted from strong foreign flows. However, any loss of foreign investor faith would be a huge knock for our bond market,” said du Plessis.

For those allocating money to interest bearing investments, these factors represent the introduction of new risks to the market. Returns generated by fixed interest portfolios are likely to be increasingly divergent, making it important to be more discriminating when making fixed income investments.