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."— Presentation transcript:
1The 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 2004Gordon Smith(+27 11)Deutsche Bank AGDeutsche 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
2Structure of presentation Executive summaryMacro drivers and relative asset performanceImpact of fiscal policy on SA’s bond marketMaturity profile and yield spread dynamicsFX risk; benchmark and ownership issuesSome conclusions and suggestions
3Executive summarySA’s bond market reflects the economy in which it operates; notably declining savings/low growth limit issuance capacityLegacy effects still cause most asset allocation professionals to shun bonds even as their recent returns have trounced equitiesImpressive fiscal reform has facilitated market consolidation, as apparent in growth in offshore sovereign/local corporate issuesYet, rand volatility/sovereign credit considerations cap foreign issuance while strong cash-flows meet corporate funding needsThe ‘off-index’ EM benchmark status of local bonds has held back foreign participation in the market, in contrast to equitiesA falling inflation premium/further sovereign credit re-rating should continue to sustain a hesitant unwind in real bond yields
4Macro drivers and relative asset performance SA bond market: Predictor of economy/policyA very brief history of SA’s macroeconomicsSA yield dynamics and structural adjustmentSA bonds outperform equities and inflationLegacy drag on institutional asset allocation
5SA bond market: Predictor of economy/policy 791113151719211987198819891990199119921993199419951996199719981999200020012002200310-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 Ratesource: I-Net Bridge; Deutsche Securitiessource: I-Net Bridge; Deutsche SecuritiesEconomic 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.
6A very brief history of SA’s macroeconomics Gross savings (% GDP, lhs)Gross capital formation (% GDP, lhs)source: I-Net Bridge; Deutsche Securities5-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
7SA yield dynamics and structural adjustment Real GDP volatility (5-year trailing average, %)10-year SAGB yieldCPI inflationCPIX inflationsource: I-Net Bridge; Deutsche Securitiessource: I-Net Bridge; Deutsche SecuritiesFalling 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
8SA bonds outperform equities and inflation 0.30.50.70.220.127.116.11985198719891991199319951997199920012003ALSI relative to ALBI Total ReturnEquity Bonds Inflation (Total return, %) (Total return, %) (CPI, %)Compound ave returnsource: Deutsche Securitiessource: I-Net Bridge, Deutsche SecuritiesWith lower cyclical economic volatility, primarily due to sustained macro-level reforms, bonds have structurally outperformed equities since 1986, but markedly so since 1994As 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.
9Legacy drag on institutional asset allocation Core Institutional asset allocation (%)10203040506070803Q014Q011Q022Q023Q024Q021Q032Q033Q034Q03EquityFixed incomesource: Alexander ForbesSA fund managers have been mandated to relatively outperform, thus institutionalising a risk bias towards equities, which are also thought to have better inflation-hedge qualitiesWhere 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
10Impact of fiscal policy on SA’s bond market Steady not stellar growth in SA bond marketSome diversification in concentrated marketFiscal conservatism drives sovereign ratingShifting issuance bias in SA bond marketCash-flows funding private capital intensity
11Steady not stellar growth in SA bond market 501001502002503003504004501986198719881989199019911992199319941995199619971998199920002001200220031020304060708090Public sector bond market cap (ZARbn, lhs)Public sector bond market cap (US$bn, rhs)20406080100120140160MexicoRussiaChinaSouth AfricaSouth KoreaPolandMalaysiaBrazilThailandIndiaIndonesiaPhilippinesTurkeyArgentinaExternal debt/GDP (%)Domestic debt/GDP (%)source: I-Net Bridge; SARBsource: Deutsche SecuritiesBond capital raising will be a function of the economy’s savings constraint; as we have seen, SA’s reforms have helped to dampen GDP risk but not yet revive trend growthIn US$ (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
12Some diversification in concentrated market SA GovernmentBonds64%Sub-sovereign10%Corporate13%SA Foreign debtZAR352bnZAR74bnZAR71bnZAR54bnTurnover 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 issuesource: BESA; SARBsource: SA National TreasuryIn their SA bond market exposure, investors face:Less domestic sovereign dominance with growth in foreign and corporate issuesConcentrated liquidity in benchmark issues; SAGB, parastatal and corporate
13Fiscal conservatism drives sovereign rating 30354045505590/9191/9292/9393/9494/9595/9696/9797/9898/9999/0000/0101/0202/0303/0404/0505/0606/07-8-7-6-5-4-3-2-1Net govt. debt/GDP (%, lhs)Budget deficit/GDP (%, rhs)345696/9797/9898/9999/0000/0101/0202/0303/0404/0505/0606/07Debt costs/GDP (%)S&P Credit RatingBBB/better?BBB-ProjectedBB+Projectedsource: SA National Treasurysource: SA National Treasury, Standard & PoorGiven 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 economyThe 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
14Shifting issuance bias in SA bond market 1020304050607080901001994199519961997199819992000200120022003Total foreign debt (ZARbn)102030405060702001200220032004Corporate bond market cap. (ZARbn)source: SARBsource: BESASA’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
15Cash-flows funding private capital intensity Share of aggregate savings (%)Private vs public sector capital formation (1995 Rbn)%/GDP Pvt. Pub09/’CorporatesPublicHouseholdsPrivateGeneral governmentsource: I-Net Bridge; Deutsche Securitiessource: I-Net Bridge; Deutsche SecuritiesWith 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 intensityFor 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
16Maturity profile and yield spread dynamics Towards a smoother SA issuance profileForeign issues: smallness means lumpinessCountry premia more relative than absoluteCredit vs. liquidity risks in corporate spreadsSpreads consistency reflects efficient marketA note on inflation-linked bonds (ILBs)...
17Towards a smoother SA issuance profile 51015202530352004/052005/062006/072007/082008/092009/102010/112011/122012/132013/142014/152015/162016/172018/192023/242025/262026/272027/282034/35Maturity profile of domestic marketable bonds (ZARbn)source: SARB
18Foreign issues: smallness means lumpiness 2.0Maturity profile of government foreign debt (US$bn)18.104.22.168.21.00.80.60.40.20.02004200520062007200820092010201120122013201420152016201720182019202020212022source: SA National Treasury
19Country premia more relative than absolute 100200300400500600700800199619971998199920002001200220032004Country risk premium* (bp)Average: 246bp3504505506507508509501050Apr-02Jul-02Oct-02Jan-03Apr-03Jul-03Oct-03Jan-0450100150200250300EMBI+ (LHS)SA US$ 10Y (RHS)Spread over USTs (bp)* 10Y SAUS$ - 10Y USTsource: I-Net Bridge; Bloomberg; Deutsche Securitiessource: I-Net Bridge; Bloomberg; Deutsche SecuritiesWhile 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 SASignificantly, 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
20Credit vs. liquidity risks in corporate spreads Spreads to SAGB equivalent (bp)-2020406080100120140160Sep-01Mar-02Sep-02Mar-03Sep-03Mar-04Corporate (NED1)Parastatal (WS03)source: I-Net Bridge; Deutsche SecuritiesSub-sovereign (parastatal) and corporate debt reflect appropriate spreads of underlying credit or earnings risk: tighter/stable for annuity cash-flow operations such as utilitiesTighter parastatal spreads also reflects implicit govt. backing of default risk. As elsewhere, credit quality determines relative spread elasticity to benchmark SAGB yield dynamics.
21Spreads consistency reflects efficient market -300-200-10010020030019951996199719981999200020012002200320045/2 yr spread10/2 yr spread10/5 yr spread2-year 5-year5-year Mean: 34bp SD: bp10-year Mean: 51bp Mean: 17bp SD: bp SD: bpsource: Deutsche SecuritiesFor a yield curve with reliable leading indicator properties, it follows that changes in relative spreads reflect appropriate risk-adjusted “bets” of bond investorsWhere 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
22A note on inflation-linked bonds (ILB’s)... 1234567Mar-00Sep-00Mar-01Sep-01Mar-02Sep-02Mar-03Sep-03ILB issuance as % of cumulative total net issuance9Breakeven inflation rates (%)10y20y85y30y7654Mar-00Sep-00Mar-01Sep-01Mar-02Sep-02Mar-03Sep-03source: SARB; SA National Treasury; BESAsource: I-Net Bridge; Deutsche SecuritiesIn 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 issuanceWhile still relatively illiquid, it is possible to derive from their real yield differentials distinct discounted future inflation expectations for comparison to consensus forecasts
23FX risk; benchmark and ownership issues SA bonds are better insulated from FX riskSA in EM: Small in bonds but big in equitiesFPI flows reflect benchmark characteristicsForeigners are mature owners of SA assetsStructural bond ownership patterns persist
24SA bonds are better insulated from FX risk 200400600800100012001400199619971998199920002001200220032004Currency risk premium* (bp)Average: 537 bp* 10Y SAGB -10Y SAUS$51015202519961997199819992000200120022003Annual volatility of ZAR/US$ (%)source: I-Net Bridge; Deutsche Securitiessource: Deutsche SecuritiesThe 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 increasedSince 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
25SA in EM: Small in bonds but big in equities 510152025MoroccoNigeriaPolandUkrainePanamaSouth AfricaArgentinaEcuadorBulgariaMalaysiaPeruVenezuelaColombiaPhilippinesTurkeyRussiaMexicoBrazilBenchmark EM bonds:Weight in EMBI+ (%)2468101214161820ColombiaVenezuelaPakistanJordanMoroccoEgyptCzech RepublicPeruPhilippinesArgentinaHungaryPolandTurkeyIndonesiaChileThailandIsraelMalaysiaRussiaIndiaMexicoChinaBrazilTaiwanSouth AfricaKoreaBenchmark EM equities:Weight in MSCI EMF (%)source: JP Morgansource: Morgan Stanley Capital InternationalDedicated 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 EMFFinancial 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
26FPI flows reflect benchmark characteristics US$ billionUS$ billionBondsEquitiesEquities13-week accumulationBondssource: I-Net Bridge, Deutsche Securitiessource: I-Net Bridge; Deutsche SecuritiesFollowing 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 deficitGiven 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
27Foreigners are mature owners of SA assets 246810121416181995199619971998199920002001Public authoritiesPublic corporationsBanking sectorNon-bank sectorGross foreign ownership of domestic debt (US$bn)510152025301995199619971998199920002001Banking sectorNon-bank sectorGross foreign ownership of domestic equity (US$bn)source: SARBsource: SARBForeign 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 splitSignificantly, 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
28Structural bond ownership patterns persist 0%20%40%60%80%100%19901991199219931994199519961997199819992000200120022003PICSARBBanksNon-bank private sectorOwnership of long-term domestic government debtsource: SARB; I-Net BridgeEven 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 yearsBy 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
29Some conclusions and suggestions Treasury deserves plaudits for macro restructuring that has helped to stabilise economy and consolidate the bond marketIt remains critical that inflation targeting success completes this contribution to a sustained re-rating in SA’s real debt costsLower real yields should be matched by further sovereign credit re-rating, and thus an ability to unwind bond market overhangsCritical to this process will be: boosting bonds’ benchmark asset allocation; reducing PIC dominance and more off-shore issuanceThis would facilitate more foreign participation as well as boost capacity for bond financing of new net fixed capital formationThe bond market is merely one financial intermediary for savings and investment, which remain a function of economic growth