SA bonds: the 'next big emerging market story'

South African bonds have become a top 2018 trade with investors.

Picture: Thomas Holder/EWN.

LONDON - Backed by a strengthening currency, some of the highest inflation-adjusted yields in emerging markets and now the possible exit of unpopular president Jacob Zuma, South African bonds have become a top 2018 trade with investors.

Recent days saw the rand jump to two-and-a-half year highs against the dollar, adding to 12% gains since mid-December, when businessman Cyril Ramaphosa took over the ruling African National Congress party with a promise to eliminate graft and make reforms needed for growth and investment.

Yields on the benchmark 10-year bond are down more than 100 basis points from late-November peaks.

Now two more factors are lending impetus to the trade.

First, if moves succeed to eject Zuma, well before his terms ends in 2019, Ramaphosa’s task of implementing some reforms becomes easier. It raises the likelihood of a prudent budget on Feb. 21 after the spending blowout outlined in the autumn policy statement.

That may, in turn, dissuade Moody’s from cutting South Africa’s last remaining investment-grade credit rating.

Ramaphosa has already moved to exert his authority, appointing a new board to stricken state-run utility Eskom and going after businessmen linked to Zuma. He is at the Davos global forum this week as part of efforts to lure back investors.

Second, the central bank predicted recently inflation would fall below 3%, the midpoint of its target band. While December’s rate quickened to 4.7%, the rand’s strength since end-November should moderate it from now.

That offers bondholders above 4 percentage points in “real” yield, less than Russia or Brazil but well above what they can get in India, Mexico, Poland or Turkey. And with the rand strong, it also means interest rate cuts are on the way.

“We have started to add (South African bonds),” said Kieran Curtis, senior investment manager at Aberdeen Standard Investments, who was underweight the market for much of 2017.

He said the risk of a costly sovereign bailout for Eskom had pressured bond markets, but now there are hopes the firm can raise finance without the government stepping in.

“If you have that rating agency issue kicked down the road, the Eskom issue kicked down the road and a very decent probability of rate cuts, it seems like a pretty comfortable position for the bond market,” Curtis said.

He added South African debt was “attractive in the global context” - and indeed, it has outgunned other emerging markets since mid-December, with the rand gaining between 6 and 12% against the lira, rouble and Brazilian real.

South African yields have fallen an average of 90 basis points in the past two months, versus a 20 bps decline on broader emerging markets, according to the GBI-EM index.

“Investors are looking for the next big EM story, akin to Brazil in 2016 and Mexico in early-2017. South Africa is at the top of the list of potential candidates,” Goldman Sachs analyst Caesar Maasry wrote, advising clients to buy bonds without hedging rand exposure.

“The strong disinflationary impulse is helping to anchor the currency... We think that the central bank will cut rates 75 bps this year. This sets up a strong potential local bond trade.”

What of the rand? Looking at it against the currencies of trade partners and adjusted for inflation - i.e. in real terms - it still looks cheap against its history. But that may not be a good gauge for the rand, given its link with metals prices, which remain weak.

With a current account gap of 2.3% of GDP, more than most emerging economies, the rand is seen by analysts at JPMorgan and UBS as already fairly valued.

But it is not just bonds that have caught investors’ attention. Despite its reliance on exports, the Johannesburg stock market has not reacted negatively to rand strength, hitting record highs along with world equities.

Morgan Stanley analysts are holding a “long” South African bond position in belief that markets will soon price out a Moody’s downgrade and instead price in rate cuts.

Noting the rand had already risen above the 12.25 per dollar rate they had predicted for end-March, they wrote: “We are more confident that our bull case is materialising, which would see rand at 11.50 (by end-2018), should the transition of power speed up.”