Allan Gray Bond Fund

South African government bonds have had a rough start to the year, as indicated by a rise in government borrowing costs (i.e. bond yields). After the SA 20-year bond yield sold off to an intra-year high of 13.2% in September 2023, it staged a recovery in late 2023 and traded down to 12.1%. Late in March 2024, roughly 80% of these gains (in price terms) had been unwound, and the bond again sold off to an elevated yield of 13.0%. Around half of this sell-off can be explained by the weakening of the 20-year US Treasury bond, as investors quite rationally questioned the market’s pricing of up to seven US rates cuts in 2024 against the reality of a strong US labour market, low unemployment and sticky inflation in US services.

The drivers of US services inflation over the last few months cover quite a range of items, like costlier prices for elder care and domestic work, hospital and veterinary services, financial services and even admission to sporting events. When an economy experiences an energy, food and fuel price shock, as seen in 2022, then it is natural to expect that a second-round shock via services-led inflation could follow. This is particularly true for an economy with a shortage of low-skilled labour, like the US. When in short supply, lower-cost labourers have a lot of bargaining power, and US wage growth is unsurprisingly still running at an elevated 5.4% year-on-year with 8.8 million job openings versus only 6.4 million unemployed workers.

The other half of the sell-off in the SA 20-year government bond can be explained by South Africa-specific factors, as seen by a widening in the risk premium of SA versus US government bonds. This relates to elevated political risk heading into South Africa’s May 2024 elections. Alongside this, the South African Budget in February was poorly received by the market, sparking some selling of bonds and limited reinvestment of fixed-rate bond coupons back into the government bond market – of which roughly R105bn was paid out to bondholders over the first three months of the year. The much-discussed lever of restructuring the South African public sector and closing redundant government departments and programmes received little airtime in the Budget. National Treasury instead agreed to monetise R150bn of the Gold and Foreign Exchange Contingency Reserve Account (GFECRA), as well as carve out an additional R100bn from this account for the Reserve Bank to use in order to pay interest on the newly printed bank reserves as a sterilisation measure.

Even with such arguably drastic measures being taken, government debt to gross domestic product (GDP) is only forecast to stabilise at 75% of GDP over the next three years from 78% prior. This is still a very elevated level of debt. While GFECRA does mean that government’s gross borrowing requirement over the next three years falls from R560bn per annum on average to R480bn per annum, it is not clear that there would be any room to cut the already-high quantum of weekly debt issuance from current levels given the government’s anaemic cash levels. The Budget also contained some relaxation of the budgetary spending restraint in the government wage bill forecasts, and we have yet to see fiscal anchors like a spending ceiling being imposed.

One concern is that now that GFECRA has been “discovered”, it will be easier to pull on this as an emergency lever as opposed to getting to the heart and underlying cause of our structural fiscal woes. In this regard, Treasury has indicated that there could be room to monetise more in future depending on the behaviour of the exchange rate. Theoretically, every one rand of exchange rate depreciation against the US dollar creates R60bn of additional GFECRA. Given this perverse hedge, it may allow government to keep monetising the account the worse that things are going in the economy, instead of using a desperate situation to enforce reform.

SA government bonds have also continued to sell off as recent polls suggest a major decline in ANC support as we head into the May 2024 elections. Early in the year, market concerns likely centred around the notion that the rising tide of economic dissatisfaction and joblessness may also have lifted the ship of populist parties like the EFF, who promise their constituents a radical redistribution of wealth. That said, the polling data is changing quickly to reflect a larger threat coming from former president Jacob Zuma’s uMkhonto weSizwe Party (MK Party), which has been polling as high as 13% nationally according to the February 2024 Brenthurst polls, taking market share from both the ANC and EFF. There are currently a range of election and coalition outcomes and clearly not all of them are positive.

In the last quarter, the Fund upweighted its allocation to senior floating-rate notes at annualised yields above 10%, to take the total allocation to floating-rate paper to approximately 30% of the Fund. It also reinvested coupons into 13-year SA government bonds as yields began to sell off but maintained its underweight duration positioning with only 45% of the Fund invested in fixed-rate government bonds. Valuations are compelling, in that a 13-year government bond bought at 12% yield would still be able to offer a five-year return of 10% per annum if it sold off to a 15% yield by the end of that period. That said, given that the Fund offers a healthy weighted average yield of 11.8% for a modified duration of 4.1, there is arguably no need to take on undue risk beyond the current allocation. A full position would also limit the ability of the Fund to participate into further price depreciation in a rising bond yield environment, which has been the status quo for the last decade in South Africa. For yields to decline on a sustained basis, we need to become an attractive investment destination again. Large pools of foreign capital have a lot of choices globally, and South Africa is small enough to ignore if the risk-reward ratio is not favourable.

Commentary contributed by Thalia Petousis