1. The South African bond market: A practitioner’s perspective of progress, problems and prospects Presentation to OECD seminar on “How to reduce debt costs in Southern Africa” , Johannesburg, 25/26 March 2004
Gordon Smith
(+27 11)
Deutsche Bank AG
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DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED AT THE END OF THE BODY OF THIS RESEARCH

2. Structure of presentation
Executive summary
Macro drivers and relative asset performance
Impact of fiscal policy on SA’s bond market
Maturity profile and yield spread dynamics
FX risk; benchmark and ownership issues
Some conclusions and suggestions

3. Executive summary
SA’s bond market reflects the economy in which it operates; notably declining savings/low growth limit issuance capacity
Legacy effects still cause most asset allocation professionals to shun bonds even as their recent returns have trounced equities
Impressive fiscal reform has facilitated market consolidation, as apparent in growth in offshore sovereign/local corporate issues
Yet, rand volatility/sovereign credit considerations cap foreign issuance while strong cash-flows meet corporate funding needs
The ‘off-index’ EM benchmark status of local bonds has held back foreign participation in the market, in contrast to equities
A falling inflation premium/further sovereign credit re-rating should continue to sustain a hesitant unwind in real bond yields

4. Macro drivers and relative asset performance
SA bond market: Predictor of economy/policy
A very brief history of SA’s macroeconomics
SA yield dynamics and structural adjustment
SA bonds outperform equities and inflation
Legacy drag on institutional asset allocation

5. SA bond market: Predictor of economy/policy7 9 11 13 15 17 19 21
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
10-year SAGB yield (%)
Base rate* (%)
10Y less 3M benchmark (led 12 mths,
lhs)
IP (12MMA,
% y-o-y, rhs)
*Pre-April 1998 Bank Rate; post-April 1998 Repo Rate
source: I-Net Bridge; Deutsche Securities
source: I-Net Bridge; Deutsche Securities
Economic efficacy: Yield curve predicts IP (most cyclical, large component of GDP) by about a year. Current spread predicting sustained turnaround in IP cycle later this year.
Policy efficacy: Bond investors/SARB constantly keeping an eye on each other, with long rates usually leading short rates by six months, except during sudden “crisis” events.

6. A very brief history of SA’s macroeconomics
Gross savings (% GDP, lhs)
Gross capital formation (% GDP, lhs)
source: I-Net Bridge; Deutsche Securities
5-year trailing real 10Y SAGB yield(%, rhs)
Macro theory would posit transmission mechanism of falling savings => falling investment => rising real rates => lower growth. SA delivered a textbook response after 1980.
Open economy macro theory would posit need for rising real rates on abolition of dual currency regime in 1995, allowing current account deficit to be adequately funded

7. SA yield dynamics and structural adjustment
Real GDP volatility (5-year trailing average, %)
10-year SAGB yield
CPI inflation
CPIX inflation
source: I-Net Bridge; Deutsche Securities
source: I-Net Bridge; Deutsche Securities
Falling cyclicality has been primarily due to halving or more of sustainable inflation since onset of 1) real rate regime (from 1988) and 2) exchange control relaxation (from 1995)
Lagged response of yields to inflation evident in rising real yields, reflects bond investors’ vigilantism towards inflation risk and thus sustainable achievement of 3-6% CPIX target

8. SA bonds outperform equities and inflation
0.3
0.5
0.7
0.9
1.1
1.3
1.5
1985
1987
1989
1991
1993
1995
1997
1999
2001
2003
ALSI relative to ALBI Total Return
Equity Bonds Inflation (Total return, %) (Total return, %) (CPI, %)
Compound ave return
source: Deutsche Securities
source: I-Net Bridge, Deutsche Securities
With lower cyclical economic volatility, primarily due to sustained macro-level reforms, bonds have structurally outperformed equities since 1986, but markedly so since 1994
As a result, bonds have been a superior inflation hedge. While this is a dire verdict on risky asset returns in the last decade, it reflects the high costs of structural adjustment.

9. Legacy drag on institutional asset allocation
Core Institutional asset allocation (%) 10 20 30 40 50 60 70 80
3Q01
4Q01
1Q02
2Q02
3Q02
4Q02
1Q03
2Q03
3Q03
4Q03
Equity
Fixed income
source: Alexander Forbes
SA fund managers have been mandated to relatively outperform, thus institutionalising a risk bias towards equities, which are also thought to have better inflation-hedge qualities
Where we have seen bond investors’ reticence to fully discount a sustained fall in inflation risk, it is no real surprise that this pro-equity asset allocation legacy continues to persist

10. Impact of fiscal policy on SA’s bond market
Steady not stellar growth in SA bond market
Some diversification in concentrated market
Fiscal conservatism drives sovereign rating
Shifting issuance bias in SA bond market
Cash-flows funding private capital intensity

11. Steady not stellar growth in SA bond market50
100
150
200
250
300
350
400
450
1986
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003 10 20 30 40 60 70 80 90
Public sector bond market cap (ZARbn, lhs)
Public sector bond market cap (US$bn, rhs) 20 40 60 80
100
120
140
160
Mexico
Russia
China
South Africa
South Korea
Poland
Malaysia
Brazil
Thailand
India
Indonesia
Philippines
Turkey
Argentina
External debt/GDP (%)
Domestic debt/GDP (%)
source: I-Net Bridge; SARB
source: Deutsche Securities
Bond capital raising will be a function of the economy’s savings constraint; as we have seen, SA’s reforms have helped to dampen GDP risk but not yet revive trend growth
In US$ (numeraire) terms, while SA’s bond market is barely changed from a generation ago, it remains comparable, in (US$) GDP terms, to Russia, China and South Korea

12. Some diversification in concentrated market
SA Government
Bonds
64%
Sub-sovereign
10%
Corporate
13%
SA Foreign debt
ZAR352bn
ZAR74bn
ZAR71bn
ZAR54bn
Turnover ratio*
R150 (2004/05/06)
R194 (2007/08/09)
R153 (2009/10/11)
R157 (2014/15/16)
R186 (2025/26/27)
R189 (ILB, 2013)
R197 (ILB, 2023)
* Market turnover/nominal outstanding issue
source: BESA; SARB
source: SA National Treasury
In their SA bond market exposure, investors face:
Less domestic sovereign dominance with growth in foreign and corporate issues
Concentrated liquidity in benchmark issues; SAGB, parastatal and corporate

13. Fiscal conservatism drives sovereign rating30 35 40 45 50 55
90/91
91/92
92/93
93/94
94/95
95/96
96/97
97/98
98/99
99/00
00/01
01/02
02/03
03/04
04/05
05/06
06/07 -8 -7 -6 -5 -4 -3 -2 -1
Net govt. debt/GDP (%, lhs)
Budget deficit/GDP (%, rhs) 3 4 5 6
96/97
97/98
98/99
99/00
00/01
01/02
02/03
03/04
04/05
05/06
06/07
Debt costs/GDP (%)
S&P Credit Rating
BBB/better?
BBB-
Projected
BB+
Projected
source: SA National Treasury
source: SA National Treasury, Standard & Poor
Given a budget deficit overhand from political settlement, reducing public sector debt was the anchor input of a wider strategy to reduce inflation and liberalise the economy
The financial payback for a steady lowering in debt service costs has been a steady improvement in SA’s credit rating, from “junk” to “investment” grade in the last decade

14. Shifting issuance bias in SA bond market10 20 30 40 50 60 70 80 90
100
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
Total foreign debt (ZARbn) 10 20 30 40 50 60 70
2001
2002
2003
2004
Corporate bond market cap. (ZARbn)
source: SARB
source: BESA
SA’s improving credit rating has continued to pave the way for more global issuance, subject to Treasury’s self-imposed current 80% (local)/20% (foreign) funding “rule”
Improving deficit and debt profiles, coupled with a steadily rising share of foreign issuance has substantially removed a crowding-out effect to abet corporate issuance

15. Cash-flows funding private capital intensity
Share of aggregate savings (%)
Private vs public sector capital formation (1995 Rbn)
%/GDP Pvt. Pub
09/’
Corporates
Public
Households
Private
General government
source: I-Net Bridge; Deutsche Securities
source: I-Net Bridge; Deutsche Securities
With aggregate savings, a lower budget deficit has on a relative basis been taken up by lower household saving, reflecting low income tax cuts and rising retail credit intensity
For SA’s financial intermediaries, as companies have met rising fixed investment needs from flush cash-flows, this has meant growth in bank credit relative to bond issuance

16. Maturity profile and yield spread dynamics
Towards a smoother SA issuance profile
Foreign issues: smallness means lumpiness
Country premia more relative than absolute
Credit vs. liquidity risks in corporate spreads
Spreads consistency reflects efficient market
A note on inflation-linked bonds (ILBs)...

17. Towards a smoother SA issuance profile5 10 15 20 25 30 35
2004/05
2005/06
2006/07
2007/08
2008/09
2009/10
2010/11
2011/12
2012/13
2013/14
2014/15
2015/16
2016/17
2018/19
2023/24
2025/26
2026/27
2027/28
2034/35
Maturity profile of domestic marketable bonds (ZARbn)
source: SARB

18. Foreign issues: smallness means lumpiness
2.0
Maturity profile of government foreign debt (US$bn)
1.8
1.6
1.4
1.2
1.0
0.8
0.6
0.4
0.2
0.0
2004
2005
2006
2007
2008
2009
2010
2011
2012
2013
2014
2015
2016
2017
2018
2019
2020
2021
2022
source: SA National Treasury

19. Country premia more relative than absolute
100
200
300
400
500
600
700
800
1996
1997
1998
1999
2000
2001
2002
2003
2004
Country risk premium* (bp)
Average: 246bp
350
450
550
650
750
850
950
1050
Apr-02
Jul-02
Oct-02
Jan-03
Apr-03
Jul-03
Oct-03
Jan-04 50
100
150
200
250
300
EMBI+ (LHS)
SA US$ 10Y (RHS)
Spread over USTs (bp)
* 10Y SAUS$ - 10Y UST
source: I-Net Bridge; Bloomberg; Deutsche Securities
source: I-Net Bridge; Bloomberg; Deutsche Securities
While SA’s sovereign risk premium has improved since 1996, so too have many other country ratings, especially the EU convergence trades, which have leap-frogged SA
Significantly, in the tightening of EM spreads since 4Q02 to risk levels last seen in 1997 (i.e. pre-Asian crisis), SA’s credit returns have mostly mirrored those of EM’s generally

20. Credit vs. liquidity risks in corporate spreads
Spreads to SAGB equivalent (bp)
-20 20 40 60 80
100
120
140
160
Sep-01
Mar-02
Sep-02
Mar-03
Sep-03
Mar-04
Corporate (NED1)
Parastatal (WS03)
source: I-Net Bridge; Deutsche Securities
Sub-sovereign (parastatal) and corporate debt reflect appropriate spreads of underlying credit or earnings risk: tighter/stable for annuity cash-flow operations such as utilities
Tighter parastatal spreads also reflects implicit govt. backing of default risk. As elsewhere, credit quality determines relative spread elasticity to benchmark SAGB yield dynamics.

21. Spreads consistency reflects efficient market
-300
-200
-100
100
200
300
1995
1996
1997
1998
1999
2000
2001
2002
2003
2004
5/2 yr spread
10/2 yr spread
10/5 yr spread
2-year 5-year
5-year Mean: 34bp SD: bp
10-year Mean: 51bp Mean: 17bp SD: bp SD: bp
source: Deutsche Securities
For a yield curve with reliable leading indicator properties, it follows that changes in relative spreads reflect appropriate risk-adjusted “bets” of bond investors
Where liquidity has been dominant in the 5-year and 10-year areas of the curve, most directional “bets” are in terms of 2-year/5-year or 2-year/10-year spread trades

22. A note on inflation-linked bonds (ILB’s)...1 2 3 4 5 6 7
Mar-00
Sep-00
Mar-01
Sep-01
Mar-02
Sep-02
Mar-03
Sep-03
ILB issuance as % of cumulative total net issuance 9
Breakeven inflation rates (%)
10y
20y 8 5y
30y 7 6 5 4
Mar-00
Sep-00
Mar-01
Sep-01
Mar-02
Sep-02
Mar-03
Sep-03
source: SARB; SA National Treasury; BESA
source: I-Net Bridge; Deutsche Securities
In tandem with the introduction of the inflation target in 2000, National Treasury has issued four ILBs across the maturity spectrum, currently accounting for 6% of issuance
While still relatively illiquid, it is possible to derive from their real yield differentials distinct discounted future inflation expectations for comparison to consensus forecasts

23. FX risk; benchmark and ownership issues
SA bonds are better insulated from FX risk
SA in EM: Small in bonds but big in equities
FPI flows reflect benchmark characteristics
Foreigners are mature owners of SA assets
Structural bond ownership patterns persist

24. SA bonds are better insulated from FX risk
200
400
600
800
1000
1200
1400
1996
1997
1998
1999
2000
2001
2002
2003
2004
Currency risk premium* (bp)
Average: 537 bp
* 10Y SAGB -10Y SAUS$ 5 10 15 20 25
1996
1997
1998
1999
2000
2001
2002
2003
Annual volatility of ZAR/US$ (%)
source: I-Net Bridge; Deutsche Securities
source: Deutsche Securities
The recent profile of FX risk is ambiguous: on one measure (relative yield derived), SA currency risk has declined but on another (FX volatility derived) it has increased
Since the former is more stable, one could conclude that local yields have become less sensitive to “pure” FX risk, a conclusion consistent with an improving sovereign rating

25. SA in EM: Small in bonds but big in equities5 10 15 20 25
Morocco
Nigeria
Poland
Ukraine
Panama
South Africa
Argentina
Ecuador
Bulgaria
Malaysia
Peru
Venezuela
Colombia
Philippines
Turkey
Russia
Mexico
Brazil
Benchmark EM bonds:
Weight in EMBI+ (%) 2 4 6 8 10 12 14 16 18 20
Colombia
Venezuela
Pakistan
Jordan
Morocco
Egypt
Czech Republic
Peru
Philippines
Argentina
Hungary
Poland
Turkey
Indonesia
Chile
Thailand
Israel
Malaysia
Russia
India
Mexico
China
Brazil
Taiwan
South Africa
Korea
Benchmark EM equities:
Weight in MSCI EMF (%)
source: JP Morgan
source: Morgan Stanley Capital International
Dedicated capital flows are an important source of capital for EM’s. For such investment, bond investors are benchmarked to the EMBI+ and equity investors by MSCI’s EMF
Financial sanctions and an alternative foreign debt restructuring left SA with a low EMBI+ weight but established, large companies ensured SA a high MSCI EMF weight

26. FPI flows reflect benchmark characteristics
US$ billion
US$ billion
Bonds
Equities
Equities
13-week accumulation
Bonds
source: I-Net Bridge, Deutsche Securities
source: I-Net Bridge; Deutsche Securities
Following the abolition of the Finrand and inclusion in benchmark indices, SA could capitalise on FPI as the main source of financing a renewed current account deficit
Given SA’s apposite benchmark status in bonds and equities has seen latter dominate FPI inflows, but “off-index”, opportunistic bond inflows can be temporarily large

27. Foreigners are mature owners of SA assets2 4 6 8 10 12 14 16 18
1995
1996
1997
1998
1999
2000
2001
Public authorities
Public corporations
Banking sector
Non-bank sector
Gross foreign ownership of domestic debt (US$bn) 5 10 15 20 25 30
1995
1996
1997
1998
1999
2000
2001
Banking sector
Non-bank sector
Gross foreign ownership of domestic equity (US$bn)
source: SARB
source: SARB
Foreign asset and liability position (for latest 2001 data) confirms foreigners’ preference for domestic equity over bonds, with a notable public vs. private source of funding split
Significantly, in US$ terms, it would appear that without further structural changes to SA’s asset markets, there is little scope for foreigners to raise their ownership stakes

28. Structural bond ownership patterns persist0%
20%
40%
60%
80%
100%
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
PIC
SARB
Banks
Non-bank private sector
Ownership of long-term domestic government debt
source: SARB; I-Net Bridge
Even as the PIC has sought to diversify its historic asset allocation bias from bonds to equities, this has been achieved via cash-flows, especially during debt-buyback years
By being on the other (asset allocation) side of the market, the PIC posted impressive relative returns from its high bond exposure, helping GEPF to close its net funding gap

29. Some conclusions and suggestions
Treasury deserves plaudits for macro restructuring that has helped to stabilise economy and consolidate the bond market
It remains critical that inflation targeting success completes this contribution to a sustained re-rating in SA’s real debt costs
Lower real yields should be matched by further sovereign credit re-rating, and thus an ability to unwind bond market overhangs
Critical to this process will be: boosting bonds’ benchmark asset allocation; reducing PIC dominance and more off-shore issuance
This would facilitate more foreign participation as well as boost capacity for bond financing of new net fixed capital formation
The bond market is merely one financial intermediary for savings and investment, which remain a function of economic growth

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Gordon Smith
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