17 June 2021
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South Africa bond market
Holdings of ZAR denominated debt by foreigners has fallen to 30% overall from around 42% in 2018. Even before COVID-19 foreigners could see South Africa as a rising sovereign risk, a risk that is now accentuated. Worryingly, commercial banks have been buying up government paper this past year as they hoarded liquidity, but there are limits to this. Government could shortly find it won’t be able to issue debt as there is no demand, regardless of the yield. Long paper is already at a discount. The sell-off in major developed country bond markets so far this year, making those bonds more attractive, means emerging market bonds are vulnerable, with South Africa among the most risky and susceptible to unpleasant newsflow.
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The Macro View
“South African bond yields – COVID-19 infected?”
South African Bond Market
If you think government’s chaotic responses to the COVID-19 pandemic was bad enough for the local economy, you haven’t seen anything yet. Our recent note “Is there a TARGET(2) on my back?” tackled a brewing eurozone horror story. But a nightmare on Church Square has been steadily unfolding too and there is no big daddy in the form of a Germany to wield a rescue bazooka. With government debt ballooning, even before COVID-19, and set to get worse, foreigners had already seen the writing on the wall and headed for the hills. Their holdings of ZAR denominated debt is the lowest in several years. Sovereign risk is simply too great and high interest rates aren’t enough to attract bond investors with certain mandates that may preclude holding South African debt. These foreigners are not ending their strike anytime soon. Meantime, local commercial banks have been increasing their holdings of government debt to the highest in several years – this is a COVID-19 phenomenon as banks have hoarded cash and raked in deposits, even as lending has stagnated. The only assets around of any decent size are bonds. But at some point, the music will stop – and government will have few if any investors around with the appetite for their sub-investment grade paper.
The South African bond market demonstrates some interesting trends over the last 6 years. The chart immediately below captures the changes in holdings of domestic South African government bonds between the four major groups of investors.
Since the first quarter of 2018, non-resident investors have sharply reduced their exposure to South African government bonds. A trend that is well-known to the markets AND also of considerable concern going forward as government’s funding requirements have become more acute AND NOT ONLY because of the Covid-19 inspired lockdown. Local pension funds have also significantly reduced their holdings of government coupon bond investments.
Who owns South African government ZAR debt?
By contrast the share of the total bond market commitment by the commercial banks in South Africa has risen sharply since the first quarter of 2020. A necessary question to ask. Is the recent surge likely to be sustained?
Over the five years to 2020, the average monthly percentage of total government bond issuance held by the banks was 16.2%. Since February 2020 that monthly average has risen to 20.9%.
Will holdings migrate back towards medium-term averages or does a new paradigm exist?
If banks retrench their most recent buying splurge National Treasury may face some serious headwinds in funding increasingly swollen government expenditures as it doesn’t look like non-resident buyers are ending their strike anytime soon.
Source: South African Reserve Bank
Over the last year commercial banks have increased their holdings of government bonds at both ends of the maturity spectrum, as the graphic below illustrates.
Short-dated and medium-term securities have been purchased as banks have sought a home for the surge in client deposits that has dominated the skewed structure of bank balance sheets since March 2020.
Source: National Treasury & South African Reserve Bank
Of equal, or even greater, significance South African banks have markedly increased the duration of their fixed income portfolios, most notably in bonds which have a term-to-maturity of 20 years and beyond.
The chart below shows the holdings of domestic SA government bonds by monetary institutions in this country. Holdings of the long-dated R2048 bond, currently trading at 80.6% of nominal have increased by 70% since May 2020, and 38% since August alone.
On the face of it this appears to be a well-conceived trade.
The South African government bond yield curve is in absolute terms very steep as the short end is going to be anchored at very low levels for quite some time while long yields express the market’s disquiet with deteriorating government finance.
As long as there are no nasty surprises with, or unsuspected holes in, government’s borrowing requirements then this trade could be extremely lucrative. Eskom’s ongoing travails with fluctuating generating capacity, which seems to be held together with bubble-gum and string, will cause a shudder through even the stoutest of hearts.
Another question facing the market is if, or when, the sell-off in major developed market bond markets will infect the long-end South African bond market?
Prices have shown some weakness since the beginning of February, in line with their international peers. An acceleration in the weakness of international fixed income markets may leave our market vulnerable into the second quarter of 2021.