The fund returned 3.75% over the last quarter, keeping its year-to-date (YTD) return (8.88%) and over the 12-month period (9.19%) well above benchmark (7.8% and 8.2% respectively).

The performance of many fixed income asset classes over the last quarter has masked increasing divergence in longer-term market expectations, resulting from heightened levels of uncertainty. Uncertainty is a familiar bedfellow of investors, and increased uncertainty historically manifests itself in asset prices. South Africa finds itself at the arduous intersect of extraordinary global and local uncertainty. Globally, the direction of monetary policy, the impact of unwinding quantitative easing and increasing political disruptions continue to obscure the macro picture. Locally, the outcome of the governing party’s leadership race and more importantly, its effect on policy implementation remain crucial for the struggling local economy. Despite all of this, South African assets have continued to defy the gravity of local fundamentals.

This past quarter saw the All Bond Index gain 3.7%. Its returns for the YTD and over a rolling one-year period, at 7.8% and 8.2% respectively, are both well above cash. While the yield of the long-term section (12 years and longer) of the All Bond Index (ALBI) is well above 9.5%, it has been the 3- to 7- year area of the bond curve that provided the best performance YTD and over 12 months. The shorter end of the bond curve has been anchored by expectations of a lower repo rate, which was eventually cut in July. In addition, strong emerging market bonds have buoyed local bonds. Over the previous quarter, the ALBI’s performance in dollar (-0.63%) was behind that of the JP Morgan Emerging Markets Bond Index (+2.41%). Still, the ALBI’s performance YTD (+8.74%) is in line with emerging markets (+8.76%). Over a rolling one-year period, the ALBI (+9.07%) is far ahead of the emerging market index (+4.18%). South Africa’s high yield relative to its emerging market peers has helped attract foreign capital and prevented any material widening in yields (capital loss), thus far.

The SA 10-year benchmark bond started the quarter just above 8.8%, touched a low point of 8.38%, but spent the majority of the quarter treading time between 8.5% and 8.6%. Despite the elevated levels of uncertainty, bond yields have not been volatile. Over the last year, the benchmark bond’s trading range (difference between the highest and lowest traded yield) has narrowed steadily to below 100bps - the lowest level in the last 20 years. This hardly seems to reflect a high level of uncertainty.

There are a few interlinked reasons that explain these low levels of volatility in the local bond market. First, it is important to distinguish between volatility and uncertainty. Volatility occurs when uncertainty suddenly materialises in definitive actions that impact asset prices. Since the Nenegate crisis, there has been an increase in uncertainty, but not an increase in definitive policy actions that have had an actual impact on underlying asset prices. Also, the market holds very different views on the implications of possible policy actions, providing very little guidance as to how asset prices should/could behave.

To us, the major concern is that the prolonged lack of definitive policy actions will further undermine the lacklustre economy, eventually triggering a stark reaction from the market. At the moment, the current subdued volatility is feeding an underlying complacency about possible market outcomes. Over the last year, low levels of volatility have allowed investors to safely earn the yields offered by local bonds. But stability begets instability. That is, investors extrapolate current stability and expect that things will always remain okay. The slightest unexpected negative event may then trigger an overreaction, and the ultimate outcome may be much more dangerous. There is only one way to protect our investors against this risk: by only investing if the underlying assets are cheap enough to withstand any short-term deterioration in fundamentals and/or volatility.

So, are South African bonds cheap enough? One way of determining the fair value of SA government bonds is by using the global risk-free rate (US 10-year bond rate), the inflation premium required when investing in local assets (the difference between expected SA and US inflation) and the riskiness of SA as a borrower (SA’s credit default spread). All inputs used in the following calculation come directly from the valuations implied by the markets. For instance, the 10-year US and SA inflation rates are implied by the 10-year nominal and inflation-linked bonds.

As is evident, SA government bonds are expensive relative to their fair value. One could argue that market expectations for SA inflation are too high and should be closer to between 5.2% and 5.5%, but similarly, the current level of the US 10-year bond probably should also be higher (perhaps 2.8% to 3%) given the impending unwinding of the US quantitative easing programme. Also, the absolute level of the SA credit spread may require extra scrutiny: the current level could be more reflective of the global ‘risk-on’ environment, and not SA’s precarious fiscal situation.

The key takeaway remains that SA government bonds are somewhere between fair value and expensive. In the short term, the global backdrop remains supportive with growth pushing higher, inflation heating up (but contained) and global yields remaining well behaved. However, local valuations do not offer any margin of safety against bad news. It is therefore, difficult to justify a long/overweight duration position in the SA 10-year bond yields.
So why are SA 10-year bond yields continuing to trade at more expensive levels? To start with, the market expects more interest rate cuts. Consumer inflation has moved lower and is expected to remain well behaved over the next two years. Meanwhile, the faltering economy is growing well below its potential, which has lowered both the SARB’s and markets’ expectations of short-term rates in the first half of the year. Following the SARB’s repo rate cut in July, the market expects the repo rate to move lower by another 0.5% over the next six to nine months. This has enhanced the attractiveness of SA bonds relative to cash and acted as a strong anchor for the bond market, keeping the upside on yields well contained. There has however been a much larger force keeping SA bond yields trading at expensive levels.
Foreign inflows into the local bond market have been substantial this year, at approximately R70 billion. This ferocious buying spree is almost on par with the pace of accumulation seen in 2012, when SA was included in the Citibank World Government Bond Index. But in 2012, the outlook for the economy was much better. In addition, SA’s credit metrics were much healthier and among the stronger of its emerging market (EM) counterparts, whereas now SA is starring down the abyss of subinvestment grade.

SA is currently benefiting from a flow of capital towards EM bonds. The market expects that global inflation will undershoot targets in the shorter term, that the unwind of quantitative easing won’t have much of an impact and that developed-market bonds will remain well-behaved. Unfortunately, all of these assumptions are based on shorter-term outcomes that can dissipate quickly. Market expectations for US rate hikes are still materially below what the Fed is guiding - to such an extent that the current market pricing of the long-term Fed target rate is 1% below the Fed’s own guidance (1.75% versus 2.75%). Investors are buying EM (and SA) bonds because they offer much higher yields, but the underlying assumptions about US yields are either very stretched or at risk of being too optimistic.

Also, consider that if SA was downgraded to below investment grade, it could result in the mandated selling of R120 to R150 billion worth of SA government bonds by passive trackers of the Citibank World Government Bond Index. It is quite difficult to see the current pace of inflows continuing to contain yields if that event were to occur. Especially in light of the fact that the SA government also needs to fund itself to the tune of R180 to R190bn every year. Foreign inflows need not reverse, but just abate, for the yields of SA government bonds to succumb to the supply dynamics.

The underlying mix of factors driving the current level of yields in the SA bond market is concerning. Low volatility has increased complacency, supported by aggressive short-term inflows into the bond market. This has created an eerie feeling of stability despite a steadily deteriorating local backdrop. Meanwhile, the international environment is becoming less friendly for carry trades. Yet investors continue to revel in delusions fuelled by the accommodative global monetary policies of yesteryear. Local bonds are at levels deemed to be on the expensive side of fair value, and do not offer a sufficient margin of safety if one of the short-term supportive factors should fall away, or the economy suffers a further deterioration. We remain cautious in our approach to investing in the local bond market. Only when bond yields are cheaper than fair value, and offer an adequate buffer against expected adverse volatility, will we look to meaningfully deploy capital into the asset class.

Portfolio managers
Nishan Maharaj and Mark le Roux as at 30 September 2017

The market enjoyed a relatively decent second quarter, with the All Bond Index up 1.5% for the quarter ending 30 June 2017, slightly behind cash (1.85%) but well ahead of inflation-linked bonds (1%). In the year to date, bonds remain the star performer in the fixed-income asset class, returning 4%, well ahead of cash (3.5%), inflation-linked bonds (0.4%) and even preference shares (2.3%), which have been the stand-out performers over the last 18 to 24 months.

The performance of local bonds was in large part a function of the strong performance of emerging markets, with the JP Morgan Emerging Markets Bond Index (EMBI) Global Diversified composite (a proxy for emerging market bond performance in dollars) returning 2.2% the second quarter and 6.2% year to date. This has supported inflows into the local bond market of approximately R40 billion this year (R21.3 billion in the second quarter), keeping local bond yields relatively well contained despite a deteriorating fundamental backdrop. Key for bond investors is whether current levels in the local bond market are sustainable - or are investors failing to see the bigger picture?

Over the last quarter, there have been some significant developments on the local front. Firstly, inflation has continued to fall and the SA Reserve Bank (SARB) has started to tilt towards monetary easing as growth collapsed, pushing SA into a technical recession. Much-needed policy reform remains hamstrung by accusations of endemic corruption at the core of government and state-owned companies, pushing policymakers further into a state of paralysis. Confidence in the economy and in the ability of policymakers to make the right decisions has continued to decline, as seen in recent business and consumer confidence indicators. This creates a vicious cycle: no new private or corporate investment is adding to the downside risks and dragging on growth momentum over the next year (and more importantly, over the longer term). The net effect is an economy with no buffer or ability to withstand any further bad news or deterioration in global risk sentiment.

The SA economy is set on a path of deteriorating creditworthiness due to worsening debt and fiscal metrics. Without serious policy action, we will have to endure further downgrades into subinvestment grade over the next 12 months. This will result in our bonds being excluded from key investment indices, which we expect will trigger large outflows from the bond market. The impact will not only be felt in the financial markets, but will inevitably affect the man on the street through higher borrowing costs and possibly higher inflation over the longer term. Accordingly, local economic prospects remain quite dim.

Since the global financial crisis (2008/2009), US 10-year real yields have fallen steadily and traded as low as -1% before settling into a range of 0% to 1% in the last five years. This has anchored global bond yields, supporting the hunt for yield into many emerging and frontier markets. The implied real yield of SA 10-year bonds, which has been oscillating between 1% and 2% above the US 10-year real yields, looked quite attractive. The implied 10-year real yield is calculated by using a static inflation assumption of the realised inflation average (5.8%) over the period. The key risks to SA government bond yields are whether US 10-year real yields (currently at 0.57%) will remain below 1% over the long term, and whether SA bonds are trading at a fair price relative to US bonds. SA’s implied 10-year real rates currently trade at a spread differential of approximately 2% to US 10-year real rates. This is probably insufficient given SA’s deteriorating macroeconomic backdrop. If anything, this spread represents the best possible scenario.

The current key US interest rate sits between 1% to 1.25%, with the Federal Reserve (Fed) expected to hike it to 3% over the longer term. Inflation in the US, as measured by the Fed’s chosen measure (personal consumption expenditure) sits at 1.4%, but is expected to move towards the Fed’s target of 2%. This implies that currently the real US policy rate is at -0.39% (very accommodative, considering that growth is above 2%). Over the longer term, this will move to around 1% (assuming inflation of 2% and the Fed’s interest rate of 3%).

Based on these numbers, it is apparent that there are two key risks to the current level of the US 10-year real rates. Firstly, the US policy rate is too accommodative, and should move towards a more appropriate level. Secondly, if the US policy rate moves towards a real rate of 1%, then US 10-year real yields at 0.57% (or even sub 1%) are not sustainable. Taking a step back to examine the bigger picture, it is clear that SA government bonds are at risk of widening given the combination of strong upside risk to US real yields and a SA risk premium that is priced only for very good domestic news.

At Coronation, we aim to construct portfolios that are well diversified, robust and resilient. So, given that we are cautious on almost 70% of its investable universe, where are we investing our bond portfolio? Two key areas in the SA bond market are starting to look quite interesting, the first being shorter-dated inflation-linked bonds (ILBs) and the second, the long end of the government curve.

The ILB curve (the lowest line in the graph overleaf) is currently very flat, with almost all bonds trading at 2.5%. SA’s repo rate is at 7%, implying a real policy rate of 1.5% (assumed inflation at 5.4%). This implies one can buy a short-dated ILB (five-year maturity) at a spread of 1% above policy rates, which is quite attractive, especially when one considers that over the next 12 to 18 months, the policy rate in SA will probably moderate by around 50 basis points (bps), which will act as a strong anchor for shorter dated ILBs. In addition, from a total return perspective, if inflation averages 5% over the next year, the five-year ILB will return 7.8%, which is slightly higher than the equivalent five-year nominal government bond. However, in the case of inflation averaging 5.5% to 6%, the ILB will return 8.33% to 8.82%. In the worst-case scenario, this asset provides one with an equivalent nominal bond return but gives one added protection in the case of an upside surprise in inflation. This makes an ILB an attractive alternative to a nominal SA government bond, especially in a traditional bond portfolio.

As we have outlined, SA 10-year government bonds are not appealing. So why would we be interested in government bonds on the longer end of the curve (more than 15 years), which traditionally are even riskier? It is important to note that at Coronation, we do not position a portfolio for only a single outcome. Our portfolios are carefully constructed to make sure that as a whole they should create attractive longer-term returns. Our historical analysis suggests that over the last 15 years the longer end of the bond curve has only a maximum of a 50% correlation to the 10-year area of the curve (if the 10-year bond rallies/sells off 100 bps, then the greater-than-20-year bond only rallies/sells off 50 bps). The SARB is likely to reduce the repo rate by 50 bps, making these longer-end bond yields of close to 10% difficult to move out 100 bps, in line with the 10-year benchmark. This implies is that we are likely to see a flattening of the bond curve in the event of a 100 bps sell-off in the benchmark. To be extra conservative, let us assume the 23-year bond sells off 80 bps, in the event of a 100 bps sell-off in the 10- year benchmark.

In periods greater than a year, the 23-year bond actually outperforms - demonstrating how powerful yield can be over the longer term. Longer-end bonds definitely carry greater risk, but investors are more than adequately compensated for this risk in the spread relative to the 10-year benchmark. Accordingly, longer-end bonds are an attractive alternative within a bond portfolio.

Given the local macroeconomic backdrop, we remain cautious. We expect low growth and policy inaction to contribute to a deterioration in SA’s fiscal and debt metrics, inevitably leading to further moves into subinvestment grade territory and index exclusion if we see no immediate policy reaction. The hunt for yield in emerging markets has diverted attention away from this deterioration. But low global real rates may not last forever, and when the easy money stops flowing into the country, it will expose SA’s harsh reality. It is for this reason that we adopt a cautious approach when it comes to investing in the local bond market. A significant repricing of local bond yields would be required for us to invest. In the interim, we do see selective value in short-dated ILBs and the longer end of the government bond curve, which provide relative value in difficult times.

Portfolio managers
Mark le Roux and Nishan Maharaj as at 30 June 2017

SA started 2017 with such promise and exuberance, as underlying drivers of the local economy entered a cyclical upswing amid what seemed to be a much calmer and supportive political landscape. In addition, the global backdrop had become (and remains) supportive of emerging markets, with the adherence of the US Federal Reserve to a gradual path of rate normalisation, continued monetary policy accommodation on the European continent and a more upbeat growth outlook, driven primarily by cyclical upswings in China and the US. The SA 10-year benchmark bond traded below 9% for most of the quarter (supported by a rally in the rand to below R12.50/$), grinding steadily towards a low point of 8.25%. Unfortunately, this rally was short lived as political events in the last week of March caused major reversals in the rand, local bond yields and sentiment towards SA.
The All Bond Index (ALBI) returned 0.4% in March, 2.5% for the first quarter of 2017 and 11% over the last 12 months. Inflation-linked bonds (ILBs) have continued to perform poorly, returning -2.15% in March, -0.5% for the quarter and 3.4% over the last 12 months. This was due to very high initial levels of implied break-even inflation (6.5% to 7%), which necessitated a move higher in real yields, as the 12-month to 18-month inflation average and profile moved considerably lower towards 5%. ILBs now trade at approximate real yields of 2.3%, which are much cheaper than previous levels and although not screaming value, still warrant consideration for inclusion into a bond portfolio.

The margin of error in forecasting can be very large; therefore, one has to ensure that the price one pays for that asset provides a sufficient margin of safety against forecasting error and short-term volatility. In the same breath, one cannot purely rely on a single measure of value to determine the attractiveness of an asset. One must utilise a few methods to validate a cheap valuation signal. The simplest way to determine the fair value of an SA government 10-year bond is to construct it as a function of global risk-free rates, inflation differentials and a country-specific risk premium, which currently suggests fair value at 8.91% (you can read more in our April issue of Corospondent).

We have applied a level of conservatism to all the variables used in the calculation, especially to SA inflation expectations, where 6% is the top end of the inflation band as well as significantly above our estimates of average inflation over the next two years (5.35%). However, SA's risk premium is the most questionable variable. In the case of further political interference and policy inaction, is it representative of a sufficient margin of safety?
SA's sovereign spread has not changed significantly following the recent credit ratings downgrades from Standard & Poor's and Fitch, as it was already pricing in sub-investment grade status (again, we discuss this in more detail in our April issue of Corospondent).
However, the more important question is how distressed could the sovereign spread get in the event of significant stress? In order to provide more context on the assumptions used in the fair value calculation, we observe the spread between SA's sovereign spread and a grouping of BBB-rated countries (countries with BBB+, BBB and BBB- ratings), currently at 80 basis points [bps]. Two key stress areas to take note of are the period in December 2015 ('Nenegate': spread of 140bps) and the period before 2000, by when S&P and Fitch had upgraded SA to investment grade status (the average spread during this period was 180 bps).

This suggests it is reasonable to expect that the current sovereign spread would need to reprice between 60 bps and 100 bps higher if the economy was to experience significantly more stress - that is, move further away from the underlying fundamentals of an investment-grade economy. Plugging in a sovereign spread that is 60 bps to 100 bps wider, suggests a fair value for SA government bonds of 9.5% to 9.9% ? significantly above the current level of 9%.

In the following two valuation metrics, we compare current yield levels to levels experienced during 'Nenegate', both from a real yield perspective and as a spread to US 10-year bonds, as this is the closest episode in our history that bears semblance to the current political landscape. SA inflation has averaged 5.8% since the start of inflation targeting, and we use this as an assumption to strip out the implied 10-year real interest rate. The current level of 3% does not compare favourably to the 3.75% average between December 2015 and February 2016. In addition, when comparing current SA 10-year government bond levels as a spread to US 10-year bond levels over the same period, the current level of 670 bps is much lower than the 740 bps to 750 bps reached during the 'Nenegate' period. On both these measures, the SA 10-year government bond fair yield should be around 9.7% to 9.8%, given the current backdrop; 70 bps to 80bps higher than current levels (discussed in more detail in our April issue of Corospondent).

ILBs are an important consideration in any fixed income portfolio as they provide an element of protection if yields sell off due to deteriorating inflation expectations. This is because their principal amount is being scaled according to the inflation rate, and therefore coupon payments are too. Key considerations include the current pricing of inflation expectations (total return expectations relative to other asset classes), and the outright level of real yields (relative to expectations and history); all within the context of ILB's greater capital risk element, given the higher modified duration carried. The following graph illustrates implied inflation expectations as represented by the difference between SA government nominal bonds and ILBs. It suggests expectations of inflation are still quite a bit higher than 6%. If you hold an ILB that matures in 2025 (currently yielding 2.35% till maturity), inflation would need to average 6.4% over the next eight years for the ILB's total return to exceed that of a nominal bond of the same maturity (currently yielding 9%). Considering that the nominal bond carries a modified duration of 6 (a 6% capital loss in the event of a 100 bps move higher in nominal yields) versus the ILB with a modified duration of 7.2 (a 7.2% capital loss in the event of a 100 bps move higher in real yields), the nominal bond seems to be the more attractive asset on a risk-adjusted basis, but only just. Considering that the real rate in SA has never sustainably been above 2.5%, a case can be made for a small holding of ILBs within a portfolio to protect against inflation being unanchored above 6% if the backdrop deteriorates further and the rand is put under greater pressure. However, one must be cognisant of symmetric probabilities in terms of the political outcome.

Ratings agencies have already started to move SA down a path into sub-investment grade, from both a local and foreign currency perspective, further souring sentiment towards SA assets. SA's inclusion in the Citi World Government Bond Index relies on our local currency debt being rated as investment grade by both Moody's and S&P - both of which will/have us one notch above local currency sub-investment grade (Moody's most likely to move soon). The continuation of the current status quo will inevitably lead to further downgrades of SA's key metrics. More specifically, growth will come under severe pressure as investment into the economy will slow. A downgrade to sub-investment grade on our local currency rating would trigger selling of SA government bonds of between R100 and R120 billion. That would be in addition to natural government issuance of R190 billion - R290 to R310 billion of net selling in a single calendar year!

Currently, increased foreign participation in the local market has been limiting the sell-off in the SA government bond market, as foreign participants have purchased almost R25 billion worth of SA government bonds year-to-date (the majority in the week following the cabinet reshuffle). The foreign reaction has been based on the supportive global backdrop, and hope of a turnaround based on the recent experiences in Brazil (following the impeachment of Dilma Rouseff as president and the consequent rally in Brazilian assets). As South Africans, we remain hopeful that the turnaround in SA will be as quick and energetic as in Brazil, but realistically one has to be honest in the assessment of the current context and circumstances in SA. There are key differences (discussed in more detail in our April issue of Corosondent) that exist that will cause the turnaround process to stretch on for a bit longer - meaning that valuations, although cheaper now, could get a whole lot cheaper.
The current environment warrants a certain degree of caution when assessing the valuation of SA government bonds. Despite this, the cyclical upswing that the economy is undergoing and the supportive global environment, political uncertainty could derail an already precariously fragile local recovery. In addition, current valuations of SA government bonds, although closer to fair value, are still some way away from offering a sufficient margin of safety in their reflected yields, especially if a downgrade of the local currency debt rating becomes more of a concern. We are therefore more cautious in our approach to SA government bonds, waiting for more widening before engaging.

The political earthquakes of 2016 have caused shock waves that will continue to reverberate across financial markets for much of the new year. Brexit and the election of Donald Trump as the new US president reflected a deep disdain and discontentment with the status quo among voters, who expressed their unhappiness with current regimes and policies. It was a stark reminder that eight years since the great financial crises, growth in many countries remained undesirably low, while income inequality has seen a market increase. Locally, although the shock of Nenegate was behind us, the political landscape remained volatile.

Despite the volatile local and global backdrop, SA bonds managed to perform much better in 2016. This was primarily due to bonds starting the year at quite elevated yields. After starting at 9.71%, the local 10-year benchmark bond traded in a range of 9.83 to 8.40%, settling at 8.92% at year-end. The All Bond Index (ALBI) delivered a total return of 15.5% for 2016, far ahead of cash at 7.05% (Short- Term Fixed Interest Composite Index) and inflation-linked bonds at 6.05%. As one would expect, with 60% of the ALBI weighted towards the 12-year and longer range of the local bond curve, these bonds delivered the biggest contribution to overall performance with 17.5% compared to 10.1% for bonds over 1 to 3 years; 13.4% (3 to 7 years) and 15.4% (7 to 12 years). Key to note here was that despite the substantial capital appreciation of bonds from their low starting point at the start of the year, the bulk of returns still came from the yield they provided. The ALBI’s return of 15.5% was composed of a 5.85% capital return (return due to an appreciation in bond prices) and a 9.65% interest return (return due to yield earned from the underlying bonds).

Over the medium to longer term, domestic inflation will continue to direct local bond yields, as will the pricing of country-specific risks and developments in the global yield environment. The performance of local bonds will therefore depend on whether current yields provide a sufficient margin of safety against adverse developments in any of these or other unforeseen events.

The outlook for local inflation has improved, primarily due to the deceleration in food inflation. Using the following base case scenario, which includes an assumption of average food inflation of 3.4% for 2017 and 4% for 2018. Even if we shock our inflation forecasts by including a move in oil to $65 per barrel and a rand slump (to R15.5/$ in the first quarter of 2017), it is still difficult to see a sustained breach of the top end of the Reserve Bank’s inflation band. In fact, inflation over 2017/2018 under our stressed scenario only averages 5.75%, compared to 5.45% under our base scenario.

The bottom line is that it is very hard, without a sustained shock to food inflation, to see the consumer price index (CPI) persistently above target over 2017/2018, with the risk very much skewed to the downside (indicated by the orange line in the graph). This is due to the abundant rainfall over much of SA during October to December 2016, as well as early indications that planning could increase by 15% in 2017 (measured even before the rainy period), providing a favourable environment for local bonds. Following on from this, it is very likely that we have seen the end of the interest rate hiking cycle in SA, with real policy rates expected to drift up to above 2% as inflation comes down next year. This will limit the SA Reserve Bank’s ability to increase policy rates further and, if anything, shift expectations towards the start of a cutting cycle in late 2017 or 2018.

The local risk premium can be represented by two key measures: the SA credit default swap (CDS) spread, which measures the sovereign’s riskiness as an issuer, and the spread between SA’s 10-year bond yield and the US 10-year bond yield.

SA’s current credit default swap (CDS) spread sits at a level of 209bps, which already prices it below investment grade. Our local budget deficit, although still wide, is projected to contract meaningfully over the next three years (by approximately 1.5%), which should reduce financing needs and costs. In addition, the weaker rand and the stable mining and manufacturing environment should also continue to promote a strong trade recovery, which should reduce our current account deficit back towards -3%. The reduction in budget and current account deficits indicates that our twin deficit problem will become more manageable over time. Our expectations of a favourable inflation outlook further implies an increase in household disposable income, thereby suggesting stronger local consumption and a more stable underpin for growth. These improvements, although by themselves not sufficient to avoid a downgrade to below investment grade, do suggest that the risks are definitely tilting towards a more positive outcome on the rating front, implying our CDS spread is somewhat too aggressively priced.

The spread between the SA 10-year government bond and the US 10-year government bond is representative of two factors, namely, the inflation differential between the two countries and the SA specific risk premium: (SA 10- year bond yield - US 10-year bond yield) = (SA inflation expectations - US inflation expectations) + SA risk premium

Currently, the spread sits at 645bps, well above the long-term average of 525bps. But more important is its implication for SA’s risk premium. The implied breakeven inflation rate for the US 10-year bond is 2%, in line with the US Federal Reserve’s (Fed) target. Our expectation of average SA inflation over the next two years is 5.5%. Using these values and the formula above, the implied SA risk premium is 295bps, compared to current market pricing of 209bps. This suggests that the implied risk premium between the SA 10-year and the US 10-year bonds provides a decent buffer in terms of risk premium expectations, making local bonds particularly attractive on this basis.

One could argue that the elevated SA-specific risk premium is due to the volatile local political landscape. However, the major local events of 2016 such as the reappointment of Pravin Gordhan as finance minister, the public prosecutor’s report on state capture, the ruling of the constitutional court against President Zuma, and the results of the local government elections suggest that political volatility is starting to near its end and the perceived risk premium is too high.

Global bond yields pushed higher after the shock result of the US election in November last year. However, to call this the start of a global bond bear market seems extreme. The prospects for European Union (EU) inflation and growth have improved, but the need for monetary policy accommodation will remain for some time as indicated by the extension of the EU quantitative easing programme. Even after the end of the programme, it will be a long time before base rates move materially above the zero level again, keeping bond yields anchored. German bond yields rose by 40bps from their lows last year but remain at 0.2% - hardly a level that strikes fear into the heart of a SA government bondholder, who earns 9%! The Fed has a target on core inflation of 2% and on keeping unemployment below 6.5%. As history has shown, it is not likely that the Fed will allow inflation to spiral out of control, causing an inflation-driven yield sell-off. In addition, with steadily decreasing levels of productivity and effective floor in the unemployment rate due to gains in technology, US real rates will be required to remain relatively low when compared to history, around the 1% to 1.5% level. This puts the medium-term nominal rate on a US 10-year bond at around 3% to 3.5% (assuming the 2% inflation target is met and maintained). We have long argued that yields below 2% for the US long bond were too expensive and fair value was somewhere around 2.5% to 3.5% over the medium term. As such, we do not believe that this is the start of a multi-decade sell-off in US bonds but merely a move towards levels that are more reflective of the underlying fundamentals and risks.

The combination of a more favourable inflation outlook in SA (with risks to the downside), flat local policy rates, a SA risk premium that prices in a good deal of conservatism and a global bond environment that should remain relatively stable, suggests a more encouraging environment for SA government bonds. SA’s 10- year and 20-year government bonds trade close to 9% and 9.6% respectively, which when taken against an inflation expectation of 5.5 to 6%, suggest a range of real returns of 2.8% to 3.9%. This is a very attractive level both from a historical and absolute perspective, enhancing the attractiveness of SA government bonds. The main risk to this outlook remains a resurgence in local political volatility that negatively influences the country’s ability to implement policy effectively. While political uncertainty has forced a more tempered approach over the previous year as well as the very near term, we maintain a more positive and constructive view on medium to longer-term outcomes.