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The South African bond market: A practitioner’s perspective of progress, problems and prospects Presentation to OECD seminar on “How to reduce debt costs.

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Presentation on theme: "The South African bond market: A practitioner’s perspective of progress, problems and prospects Presentation to OECD seminar on “How to reduce debt costs."— Presentation transcript:

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 Deutsche Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED AT THE END OF THE BODY OF THIS RESEARCH

2 2 Structure of presentation t Executive summary t Macro drivers and relative asset performance t Impact of fiscal policy on SA’s bond market t Maturity profile and yield spread dynamics t FX risk; benchmark and ownership issues t Some conclusions and suggestions

3 3 Executive summary t SA’s bond market reflects the economy in which it operates; notably declining savings/low growth limit issuance capacity t Legacy effects still cause most asset allocation professionals to shun bonds even as their recent returns have trounced equities t Impressive fiscal reform has facilitated market consolidation, as apparent in growth in offshore sovereign/local corporate issues t Yet, rand volatility/sovereign credit considerations cap foreign issuance while strong cash-flows meet corporate funding needs t The ‘off-index’ EM benchmark status of local bonds has held back foreign participation in the market, in contrast to equities t A falling inflation premium/further sovereign credit re-rating should continue to sustain a hesitant unwind in real bond yields

4 4 Macro drivers and relative asset performance t SA bond market: Predictor of economy/policy t A very brief history of SA’s macroeconomics t SA yield dynamics and structural adjustment t SA bonds outperform equities and inflation t Legacy drag on institutional asset allocation

5 5 SA bond market: Predictor of economy/policy t 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. t 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. source: I-Net Bridge; Deutsche Securities 10Y less 3M benchmark (led 12 mths, lhs) IP (12MMA, % y-o-y, rhs) year SAGB yield (%) Base rate* (%) *Pre-April 1998 Bank Rate; post-April 1998 Repo Rate

6 6 A very brief history of SA’s macroeconomics t Macro theory would posit transmission mechanism of falling savings => falling investment => rising real rates => lower growth. SA delivered a textbook response after t 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 source: I-Net Bridge; Deutsche Securities Gross capital formation (% GDP, lhs) Gross savings (% GDP, lhs) 5-year trailing real 10Y SAGB yield(%, rhs)

7 7 SA yield dynamics and structural adjustment t 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) t 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 source: I-Net Bridge; Deutsche Securities Real GDP volatility (5-year trailing average, %) source: I-Net Bridge; Deutsche Securities CPI inflation 10-year SAGB yield CPIX inflation

8 8 SA bonds outperform equities and inflation t With lower cyclical economic volatility, primarily due to sustained macro-level reforms, bonds have structurally outperformed equities since 1986, but markedly so since 1994 t 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. source: Deutsche Securitiessource: I-Net Bridge, Deutsche Securities ALSI relative to ALBI Total Return EquityBondsInflation (Total return, %)(Total return, %)(CPI, %) Compound ave return

9 9 Legacy drag on institutional asset allocation t 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 t 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 source: Alexander Forbes Q014Q011Q022Q023Q024Q021Q032Q033Q034Q03 EquityFixed income Core Institutional asset allocation (%)

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

11 11 Steady not stellar growth in SA bond market t 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 t 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 source: I-Net Bridge; SARBsource: Deutsche Securities Mexico Russia China South Africa South Korea Poland Malaysia Brazil Thailand India Indonesia Philippines Turkey Argentina External debt/GDP (%) Domestic debt/GDP (%)

12 12 t In their SA bond market exposure, investors face: s Less domestic sovereign dominance with growth in foreign and corporate issues s Concentrated liquidity in benchmark issues; SAGB, parastatal and corporate source: BESA; SARB Some diversification in concentrated market SA Government Bonds 64% Sub-sovereign 10% Corporate 13% SA Foreign debt 13% ZAR352bn ZAR74bn ZAR71bn ZAR54bn source: SA National Treasury 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

13 13 Fiscal conservatism drives sovereign rating t 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 t 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 source: SA National Treasurysource: SA National Treasury, Standard & Poor /9797/9898/9999/0000/0101/0202/0303/0404/0505/0606/07 Debt costs/GDP (%) S&P Credit Rating BB+ BBB- BBB/better? Projected

14 14 Shifting issuance bias in SA bond market t 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” t 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 source: SARBsource: BESA Total foreign debt (ZARbn) Corporate bond market cap. (ZARbn)

15 15 Cash-flows funding private capital intensity t 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 t 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 source: I-Net Bridge; Deutsche Securities Share of aggregate savings (%) General government Households Corporates Private vs public sector capital formation (1995 Rbn) Private Public %/GDPPvt.Pub /’

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

17 17 Towards a smoother SA issuance profile source: SARB /052005/062006/072007/082008/092009/102010/112011/122012/132013/142014/152015/162016/172018/192023/242025/262026/272027/282034/35 Maturity profile of domestic marketable bonds (ZARbn )

18 18 Foreign issues: smallness means lumpiness source: SA National Treasury Maturity profile of government foreign debt (US$bn)

19 19 Country premia more relative than absolute t 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 t 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 source: I-Net Bridge; Bloomberg; Deutsche Securities Country risk premium* (bp) Average: 246bp * 10Y SAUS$ - 10Y UST

20 20 Credit vs. liquidity risks in corporate spreads t 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 t Tighter parastatal spreads also reflects implicit govt. backing of default risk. As elsewhere, credit quality determines relative spread elasticity to benchmark SAGB yield dynamics. source: I-Net Bridge; Deutsche Securities Spreads to SAGB equivalent (bp)

21 21 Spreads consistency reflects efficient market t For a yield curve with reliable leading indicator properties, it follows that changes in relative spreads reflect appropriate risk-adjusted “bets” of bond investors t 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 source: Deutsche Securities /2 yr spread 10/2 yr spread 10/5 yr spread 2-year5-year 5-yearMean: 34bp SD: 73bp 10-yearMean: 51bpMean: 17bp SD: 96bpSD: 29bp

22 22 A note on inflation-linked bonds (ILB’s)... t 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 t While still relatively illiquid, it is possible to derive from their real yield differentials distinct discounted future inflation expectations for comparison to consensus forecasts source: SARB; SA National Treasury; BESAsource: I-Net Bridge; Deutsche Securities Mar-00 Sep-00 Mar-01 Sep-01 Mar-02 Sep-02 Mar-03 Sep-03 ILB issuance as % of cumulative total net issuance Mar-00 Sep-00 Mar-01 Sep-01 Mar-02 Sep-02 Mar-03 Sep-03 10y 20y 5y 30y Breakeven inflation rates (%)

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

24 24 SA bonds are better insulated from FX risk t 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 t 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 source: I-Net Bridge; Deutsche Securitiessource: Deutsche Securities Currency risk premium* (bp) Average: 537 bp * 10Y SAGB -10Y SAUS$ Annual volatility of ZAR/US$ (%)

25 25 SA in EM: Small in bonds but big in equities t 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 t 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 source: JP Morgansource: Morgan Stanley Capital International 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+ (%)

26 26 FPI flows reflect benchmark characteristics t 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 t 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 source: I-Net Bridge, Deutsche Securitiessource: I-Net Bridge; Deutsche Securities Bonds Equities 13-week accumulation Bonds Equities US$ billion

27 27 Foreigners are mature owners of SA assets t 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 t 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 source: SARB Public authoritiesPublic corporations Banking sectorNon-bank sector Gross foreign ownership of domestic debt (US$bn) Banking sectorNon-bank sector Gross foreign ownership of domestic equity (US$bn)

28 28 Structural bond ownership patterns persist t 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 t 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 source: SARB; I-Net Bridge 0% 20% 40% 60% 80% 100% PICSARBBanksNon-bank private sector Ownership of long-term domestic government debt

29 29 Some conclusions and suggestions t Treasury deserves plaudits for macro restructuring that has helped to stabilise economy and consolidate the bond market t It remains critical that inflation targeting success completes this contribution to a sustained re-rating in SA’s real debt costs t Lower real yields should be matched by further sovereign credit re-rating, and thus an ability to unwind bond market overhangs t Critical to this process will be: boosting bonds’ benchmark asset allocation; reducing PIC dominance and more off-shore issuance t This would facilitate more foreign participation as well as boost capacity for bond financing of new net fixed capital formation t The bond market is merely one financial intermediary for savings and investment, which remain a function of economic growth

30 30 Disclaimer Deutsche Member of the Deutsche Bank Group Publisher: Deutsche Securities (Pty) Ltd, 3 Exchange Square, 87 Maude Street, Sandton, 2196, South Africa. Author: As referred to on the front cover. All rights reserved. When quoting, please cite Deutsche Securities Research as the source The information and opinions in this report were prepared by Deutsche Bank AG or one of its affiliates (collectively “Deutsche Bank”). The information herein is believed by Deutsche Bank to be reliable and has been obtained from public sources believed to be reliable, but Deutsche Bank makes no representation as to the accuracy or completeness of such information. Deutsche Bank may engage in securities transactions in a manner inconsistent with this research report and with respect to securities covered by this report, will sell to or buy from customers on a principal basis. Disclosures of conflicts of interest, if any, are discussed at the end of the text of this report or on the Deutsche Bank website at Opinions, estimates and projections in this report constitute the current judgement of the author as of the date of this report. They do not necessarily reflect the opinions of Deutsche Bank and are subject to change without notice. Deutsche Bank has no obligation to update, modify or amend this report or to otherwise notify a reader thereof in the event that any matter stated herein, or any opinion, projection, forecast or estimate set forth herein, changes or subsequently becomes inaccurate, or if research on the subject company is withdrawn. Prices and availability of financial instruments also are subject to change without notice. This report is provided for informational purposes only. It is not to be construed as an offer to buy or sell or a solicitation of an offer to buy or sell any financial instruments or to participate in any particular trading strategy in any jurisdiction. The financial instruments discussed in this report may not be suitable for all investors and investors must make their own investment decisions using their own independent advisors as they believe necessary and based upon their specific financial situations and investment objectives. If a financial instrument is denominated in a currency other than an investor’s currency, a change in exchange rates may adversely affect the price or value of, or the income derived from, the financial instrument, and such investor effectively assumes currency risk. In addition, income from an investment may fluctuate and the price or value of financial instruments described in this report, either directly or indirectly, may rise or fall. Furthermore, past performance is not necessarily indicative of future results. Unless governing law provides otherwise, all transactions should be executed through the Deutsche Bank entity in the investor’s home jurisdiction. In the US this report is approved and/or distributed by Deutsche Bank Securities Inc, a member of the NYSE, the NASD, NFA and SIPC. In the United Kingdom this report is approved and/or communicated by Deutsche Bank AG London, a member of the London Stock Exchange. This report is distributed in Hong Kong by Deutsche Bank AG, Hong Kong Branch, in Korea by Deutsche Securities Korea Co and in Singapore by Deutsche Bank AG, Singapore Branch. In Japan this report is approved and/or distributed by Deutsche Securities Ltd, Tokyo Branch. Deutsche Bank AG Johannesburg is incorporated in the Federal Republic of Germany (Branch Register Number in South Africa: 1998/003298/10). ADDITIONAL INFORMATION RELATIVE TO SECURITIES, OTHER FINANCIAL PRODUCTS OR ISSUERS DISCUSSED IN THIS REPORT IS AVAILABLE UPON REQUEST. This report may not be reproduced, distributed or published by any person for any purpose without Deutsche Bank's prior written consent. Please cite source when quoting. Copyright © 2004 Deutsche Bank AG Additional Information Available upon Request For disclosures pertaining to recommendations or estimates made on a security mentioned in this report, please see the most recently published company report or visit our global disclosure look-up page on our website at The views expressed in this report accurately reflect the personal views of the undersigned lead analyst about the subject issuers and the securities of those issuers. In addition, the undersigned lead analyst has not and will not receive any compensation for providing a specific recommendation or view in this report. Gordon Smith Deutsche Bank research ratings key Buy:Total return expected to appreciate 10% or more over a 12-month period. Hold:Total return expected to be between 10% to ‑ 10% over a 12-month period. Sell:Total return expected to depreciate 10% or more over a 12-month period.


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