The hunt for yield gains momentum

Developed market bond yields continued to trend lower. Yields on the benchmark US 10-year bond declined 34 basis points from 2% at the end of June to 1.66%. In Europe, the yield on the German 10-year Bund touched a new all-time low of -0.716%. The difference between the US 2-year and 10-year bond collapsed 20 basis points and briefly inverted before the curve re-steepened. However, the inversion between the 10-year bond yield and the Federal Reserve (Fed)’s overnight rate has persisted since mid-May. An inverted yield curve has preceded every recession in the US over the past 50 years.

Despite rate cuts and the subsequent fall in bond yields, US rates remain the highest among G10 countries. A combination of better growth and higher yields relative to the peers led to a stronger Dollar, which gained 3.4% on a trade-weighted basis.

Globally, the stock of negative-yielding debt touched new highs at $17 trillion, however, with the sell-off in September negative-yielding debt declined to about $14 trillion.

On 17 September, the Fed’s secured overnight financing rate (repo rate) touched 10% intraday. The repo rate is the rate at which the primary dealers finance long positions. Under normal market conditions this rate should trade at a similar level to the effective federal funds rate. The dislocation that occurred in September was blamed on quarterly tax payments and settlement of a large T-bill auction. The Fed responded by injecting $75 billion into markets, the first time if has done so since the credit crises. The Fed also announced that this liquidity facility will be available until 4 November.

Local Market Review

In July, the minister of finance announced plans to increase support for Eskom by an additional R59 billion over the next two years. An allocation of R26 billion was made for the current year in addition to the R23 billion announced in the February budget. The increased support for state-owned companies (SOCs) and lower revenue collection by the South African Revenue Service increased the funding requirement for National Treasury. Weekly nominal bond auctions were increased to R4.53 billion from R3.3 billion while the inflation-linked bond auction volume increased to R1.07 billion from R0.67 billion. Prior to the increased issuance announcements bond yields had traded to 14-month lows. The benchmark R186 traded to 7.97% before selling off to 8.47%. The yield curve shape did not react much to the increased bond supply, however, the flattening that would have been expected as bond yields moved higher did not happen. Fitch changed South Africa’s rating outlook from stable to negative due to the increased support for Eskom, while Moody’s also said the move was credit-negative.

The FTSE/JSE All Bond Index returned 0.78% for the quarter, underperforming the SteFI cash index return of 1.83%. The 3-7-year sector delivered the best return of 1.29%. The yield on the benchmark R186 rose 0.235% to 8.32% while the R2035 (16-year bond) yield rose 0.17% to 9.61%.

With inflation remaining relatively subdued, demand for inflation protection has been week. The inflation-linked index returned just 0.25% for the quarter. Yields on the I2029 (10-year bond) rose 0.24% from 3.17% to 3.41%. The yield on the ultra-long I2050 reached a new high of 3.65% in September before ending the quarter at 3.63%.

Credit spreads continued to tighten even as fundamentals have deteriorated. While we do not expect an eminent reversal of the trend, we have noticed that auctions are starting to price within price guidance, rather than below, and market orders to sell are getting longer. We used the opportunity to selectively reduce exposure.

Bond Market Outlook

Contrary to our expectations local factors were the main determinants of performance over the past three months, particularly revenue shortfall and bailouts of SOCs, which pushed projected fiscal deficits for 2019/20 to about 6%. As we head into the Medium Term Budget Policy Statement (MTBPS) the market will fret about National Treasury’s ability to get spending under control. Failure to show a credible fiscal consolidation path will result in heightened rating downgrade risk. The underperformance of South African bonds relative to emerging market peers should have resulted in attractive valuations and this should support the market in any selloff.

In developed markets we think the Fed will continue to ease monetary policy to support growth in the face of continuing tensions and slowing growth. Locally we do not expect the South African Reserve Bank to cut the repo rate in the remaining meeting this year.

We continue to favour nominal bonds over inflation-linked bonds and credit.

Market comments

Developed market yields continued to trend lower. Yields on the benchmark US 10- year bond declined 47 basis points during the quarter from 2.479% to 2.005%. In Europe, the yield on the 10-year German Bund touched a new all-time low of - 0.329%. In its June statement the Federal Open Market Committee (FOMC) acknowledged that economic growth was slowing somewhat and in describing future interest rate changes the statement said the FOMC will ‘closely monitor/ will act as appropriate’. While the FOMC did not signal a July rate cut, the Fed dot plot showed that most participants expect the federal funds rate to be at 2.1% at the end of 2020, compared to 2.6% previously. The federal funds futures market continues to expect much deeper cuts than the FOMC. The primary driver for the more dovish stance has been inflation that has remained below the 2% target despite low unemployment. However, the ongoing ‘trade war’ between the US and its trading partners is leading to an uncertain economic environment and greater demand for safe assets. The stock of debt with negative yields reached a new record of US$12.5 trillion.

Among the G20 countries, six have lowered monetary policy rates so far this year, with only the Czech Republic that has raised rates.

Bond market review

Cyril Ramaphosa’s ANC was victorious in the April general elections. While a victory was never in doubt, the markets were worried that the ANC might not achieve a convincing win, which could result in a weakened president and political uncertainty. However, Ramaphoria Part Two has not taken place because investors have a more realistic appreciation of the challenges that South Africa faces. It has emerged that Eskom is likely to need bigger bailouts than was provided for in the February budget. Secondly, the poor economic growth performance in the first quarter, and the expectation of sub-1% growth for 2019, has heightened the fiscal risks that the country is facing. The front and intermediate bonds rallied along with developed market bonds but the back-end bonds did not follow, resulting in a sharply steeper curve. The yield on the R2023 (5-year) bond rallied 41 basis points, while the yields on the R2048 (30-year) bond rose 9 basis points. The FTSE/JSE All Bond Index returned 3.7% for the quarter, with the ‘belly’ of the curve delivering the best performance. The 7-12-year sector delivered a return of 4.61%. Foreign investors sold roughly R20 billion worth of bonds during the quarter, despite the more favourable global bond environment.

With inflation remaining at or below target, demand for inflation protection was quite variable. In April yields on inflation-linked bonds rallied across the curve only to give up some of the gains in May and June as yields rose and the curve steepened. Despite that, the CILI (JSE Total Return Inflation-Linked Series) returned 2.76%, outperforming the STeFI return of 1.8%.

Demand for corporate credit was again robust, with credit spreads continuing to compress. Our exposures remained largely unchanged owing to the obvious signs of economic stress in a number of sectors.

Bond market outlook

Over the next three months we expect global forces to overwhelm local factors. The ‘coordinated’ global monetary policy easing is likely to create demand for SA bonds as our bonds offer some of the highest yields in developing markets. However, we remain concerned with the fiscal trajectory and seemingly low appetite for structural reforms that will lead to short-term pain but better growth prospects in the future.

The South African Reserve Bank (SARB) said that their Quarterly Projection Model indicated that there is scope to reduce the repo rate. For some time now we held the view that the SARB’s monetary policy stance was restrictive rather than accommodative and should the economy continue to falter, then the SARB could cut rates. We think that the SARB will cut rates soon but given the risks of downgrades and capital outflows, the cutting cycle is unlikely to be deep.

The 'Fed Put' is the belief that the US Federal Reserve (Fed) can always rescue the economy (and markets) by lowering interest rates. Markets were very volatile at the end of 2018 and it seems like the Fed Put is alive and well. The Fed turned outright dovish in January, with various governors indicating that they favoured leaving rates at current levels for an extended period because inflation had remained low. Yields on the benchmark US 10-year bond fell to 2.40% from 2.62% after the March Federal Open Market Committee meeting wherein the Fed 'dot plots' indicated that the Fed was unlikely to raise rates this year and the median 'dots' indicated only one rate increase in 2020. In Germany and China indicators of growth such as the Manufacturing Purchasing Managers' Index (PMI) have printed lower than expectations, resulting in monetary stimulus in China and expectations of continued accommodation in Europe. German and Japanese 10-year bond yields rallied to - 0.07% and -0.09% respectively. The global stock of bonds trading with negative yields increased from US$8.325 trillion in January to US$10.353 trillion at the end of the quarter.

Bond Market Review

Minister of Finance Tito Mboweni delivered the national budget in February, which forecast deficits of over 4% over the medium term. In the budget, government also allocated R69 billion to Eskom, but failed to do so in a deficit-neutral way. The financing requirement is projected to increase to R335 billion in the 2019/20 fiscal year from R239 billion previously. R216 billion will be financed via local bonds, R65 billion will come from cash resources and the balance from T-Bills and offshore bonds.

In February and March South Africa experienced stage 4 load shedding, which is expected to have a negative impact on the first-quarter growth rate. Yields on South African bonds underperformed the rally in developed markets partly because of increased risk of a credit downgrade from Moody's, which would have resulted in South Africa losing its investment-grade status and falling out of the World Government Bond Index. Moody's was scheduled to announce its latest credit opinion on South Africa on 29 March.

Foreign investors bought R11.3 billion of South African bonds in January as emerging market funds attracted a lot of inflows, however, flows turned slightly negative in February as worries about global economic slowdown increased and country-specific issues dominated.

With inflation printing at 4% and 4.1% in January and February respectively, demand on inflation protection has been low. Inflation-linked bonds (ILBs) have continued to underperform nominal bonds. The Government Issued Bonds (IGOV) Index returned just 0.5% for the quarter compared to the FTSE/JSE All Bond Index return of 3.76%. Yields on the 15-year ILB (R202) traded at 3.32%, their highest level since June 2009, and the long-dated I2025 touched a new high of 3.42%.

We saw continued spread tightening on corporate bonds in the past quarter. Another standout feature was the large number of privately placed bonds rather than public auctions. Spread tightening is happening despite obvious signs of financial stress in a number of sectors and as a result we did not increase exposure to credit.

We view the global growth slowdown as a 'mid-cycle' slowdown rather than the beginning of a recession, particularly in the US, where the economy still has good momentum. If we are correct, then the Fed is unlikely to cut rates and their next move could well be up. Ten-year bond yields at 2.4%, below three-month cash rates, require rate cuts to be sustained.

In South Africa we have seen growth forecasts revised lower in part due to load shedding, slow credit growth and weaker consumer spending. Inflation risks are low, but downgrade risk is going to remain high and the South African Reserve Bank (SARB) is likely to err on the side of caution and leave policy rates unchanged. Unlike the SARB we think current policy is restrictive rather than accommodative and should the economy continue to falter, then the SARB could cut rates.

Given yields available on one- and two-year negotiable certificates of deposit and our benign inflation outlook, risk-adjusted returns on cash are very attractive relative to bonds. ILBs is the least favoured fixed-income asset class.