Wealthcast: The South African bond market and offshore portfolios

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Recorded on 29 May 2020

This transcript has been lightly edited for clarity.

Mike Abbott: Roeloff, thanks so much for joining us. It's an absolute pleasure to have you with us. Just for our listeners to know, we work a lot with MitonOptimal and Roeloff is on our investment committee for our global living annuity solution and so we have many interesting investment conversations with Roeloff. So he's very generously given us some of his time today to have a discussion around the SA financial markets. Thanks for joining us, Roeloff.

Roeloff Horne: You're welcome Mike.

MA: So Roeloff, with SA now being downgraded by all the agencies and dropping out of the FTSE WGBI Index, what do you see in the data around capital outflows from South Africa around this time?

RH: Mike, the most recent data is hard to obtain but what we have seen is actually a lot of buying from both locals and foreigners. At one stage, our 10-year government bond – during the downgrade period, which was coincided by the COVID lockdown economic collapse in capital market, we had a big sell off.

It's not COVID-19 that's threatening economies globally, it's more the lockdown processes that caused the economic slowdown and uncertainty.

So foreigners and maybe some locals pre-empted the downgrade and sold off SA bonds and the yields spiked by almost 3% from 9% to 12% and that's come right back to 9% again. So you've had a situation where we had a lot of outflows in March for maybe more reasons than just the downgrade, maybe South Africa's ability to pay debt, also in the COVID-19 lockdown crisis. I'd like to provide listeners with the objective analogy that it's not COVID-19 that's threatening economies globally, it's more the lockdown processes that caused the economic slowdown and uncertainty.

So what you have is actually outflows in March and inflows after the downgrade and that's typical. We've studied the downgrade scenarios in Brazil and other areas in Asia and it's typical – what's happened here is very typical relative to what's happened in the past in other countries where there's a sell off ahead of the event and then post the event you actually have opportunists who actually used the yield as an ability to maybe trade in the short term, which is risky for our situation, but actually we've had inflows over the last month and a half.

MA: Very interesting.

Niel Pretorius: Yeah, Roeloff, as far as South Africa's debt obligation goes, the impact on investors, it sounds like it's been pretty muted besides the short spike with the outflows and then inflows again?

RH: You know, it's a very good question because, Niel, the effects for investors are different. Let me explain. So, let's take money market yields. That's now, I think it's something like 2.25% the effect of money market yields and cash yields that's now dropped because of the repo and lending rate that's been reduced by the SA Reserve Bank. So that's very positive for people with a lot of debt as consumers in South Africa. So they're going to pay a smaller portion of their income to interest payments, whether it's on their bond or their vehicle financing.

So that's positive for the consumer, but now for the investor, the pensioner, that have relied on money market safe investment at 7.5 / 8% depending over the last three/four years, that money market rate's now going to drop to very close to 4% in the near term. So for investors that are hiding or parking their assets in grant money market funds, they're soon going to be very surprised and negatively impacted with the lowering of rates for the short end of the market.

Now, that said, you look at a corporate. Now whether you are a growth point or a large property company, or whether you're corporate and you want to go to the market and actually generate some capital by asking the market to lend you some capital, which is a very standard procedure in all capital markets… so the credit mechanism now has actually worsened for corporates. Why do I say that? The cost of debt for corporates and for business is going to go up because you had the downgrade, the cost of debt has now increased from 9% to 12% recently. But because of the downgrade, and not because of the 9% yield or the 12% yield, the market looks at South Africa and at their banks in a negative approach, meaning that the debt rating is lower than before.

It's a very weird anomaly that we face at the moment.

We are junk status. So therefore, what investors expect globally and locally from banks, as well as any corporate that comes to the market for lending practice, they want to be paid for assuming the risk involved. So the cost of debt bottom line for banks, who issue bonds to raise capital for corporate who issue bonds to raise capital has increased and that's not good for the equity market or the corporate market where they need capital to deploy in terms of investment into the country or to deploy capital to grow their business or their earnings streak.

So that's interesting how things like a downgrade actually affects the cost of debt for corporates negatively and for banks negatively, but for the consumer it's actually getting better – but not because of the downgrade – because of the economic conditions and the lockdown and the economic slowdown so the Reserve Bank has actually cut rates. So all of a sudden the consumer's in a better space, but the corporate that wants to issue bonds to generate capital for their balance sheet to deploy it in terms of economic outlook or business growth is now limited and their cost of debt has gone up so it's a very weird anomaly that we face at the moment.

MA: So Roeloff that brings me to another question, which is something I've been hearing from other quarters as well as from people who are involved in the bond markets in South Africa, is that now because of that situation you've got the corporate and government debt yields relative to, on a risk adjusted basement basis and on an inflation adjusted basement from a real yield point of view, now look quite interesting, quite attractive, to a foreign bond manager who's got a portion of his portfolio that's chasing that kind of yield. So have we seen some action in that sphere of international bond market flows into the South African market to pick up that yield?

The better risk-adjusted, short-term investment is to look at the bond yields.

RH: Yes we did, Mike, and that explains why we've actually had inflows in the last while and why, indirectly, the Rand benefited from those inflows because the speculators – there's a big hedge fund that also invested in SA bonds expecting a 15% dollar yield over time by investing in SA bonds, so he took a very positive view of South Africa by investing in our bond yields – so to answer your question, there's been inflows and also local pension funds, local asset managers, all understand the economic conditions that are kind of challenging for corporate at the moment to generate positive earnings growth. Therefore, the better risk-adjusted, short-term investment is to look at the bond yields as said at one stage it traded at 12%, today it's closer to 9% for our 10-year yields. Our five-year yields are closer to 7.5%. Now take that and just assume no volatility over five years and you just get 7.5. Inflation's projected to be at 3.5% at the moment. That's a 4% real yield. That's attractive for an investor because you're outperforming inflation by 4%. That's only in the short term for a five-year bond. You go longer, you take more risk by buying a 10-year bond, you get a 9% yield. That now means 5.5% yield expectation. So it's definitely, from a risk-adjusted basis, a more appropriate investment relative to the uncertainty of buying a local equity portfolio with very uncertain earnings projections.

Bonds have now out-performed the SA equity market over five, I think, almost six years.

Even dividends are not guaranteed at the moment because of the fiscal stimulus that some of them may get or relief packages that they may get, so there's an uncertain earnings scenario in South African equities, but a more certain return in terms of bonds, which makes it more attractive and bonds have now out-performed the SA equity market over five, I think, almost six years and obviously also year to date. But all of that said it doesn't mean it's a slam dunk because the negative of our situation in South Africa is that we're forced to issue a lot more debt going forward to be able to service our economic demands in our country.

MA: So with the downgrade, that obviously affected our credit worthiness as far as the foreign currency denominated debt is concerned. Now equally the largest part of our debt is in local currencies and Rand. And there we fall under a different index. Do ratings affect that at all?

RH: No, it's quite interesting. Good question. Because everyone talks about the World Government Bond Index where we have now dropped out because we're now fully junk, but there's an emerging market index called the JP Morgan Government Bond Index, which is a number of emerging market countries in local currency and we form part of that. I think we're like 7.5% of that index. There the downgrade doesn't affect the index investors in that index and funny enough our offshore fund is actually buying those local currency bonds at the moment, so even we are, from a global perspective as a Dollar investor, buying the government bond index in emerging market currencies, which we form part of. So, to answer your question, no it doesn't affect the Emerging Market Bond Index, but then obviously with the World Government Bond Index our credit rating has been affected negatively so that index can't buy our bonds.

MA: And Roeloff, do you think we're in a situation where the issue of capital controls or the tightening of capital controls is likely to come onto the agenda?

RH: It's a tough question, Mike, because I don't know how the government thinks, but the information we get from political analysts – and there's a few of them that are close to government – it's fair to say that the government does need to generate income, which is going to be tough because of the tax base locally being under pressure, the consumers will be under pressure. So if you don't have a strong tax base to serve as your interest, you have to issue bonds and if the global bond market still buys your bonds you're okay for a period because it means you can maybe by issuing bonds, service your debt interest, but the fact remains longer term and even in the short term our government's under pressure to deal with SOEs and the local economy. So the question relating to capital controls we think will be more subtle, rather than an aggressive capital control implementation.

What I mean by that is that you know Regulation 28 where pension funds, retirement annuities, compulsory assets have certain rules. The one rule is that there's a 30% foreign allowance. You can only invest into foreign assets up to 30% in those pension funds and retirement annuities and maybe 5% is the maximum for Africa and then there's other rules that govern that. We think that maybe what they may do is just limit the 30% back to 25% where they were I think three or four years ago, and that will force big pension funds, local investment managers to sell off 5% globally, bringing it back locally and due to the fact that bond yields are so attractive, the natural implication may be that these asset managers will then buy our bonds and actually finance the government in that way.

We don't see a scenario where SA citizens may not transfer capital anymore or that they have to bring their capital back, because they're still SA taxpayers or citizens.

Doing it that way is much safer from a global perspective. So we don't see a scenario where SA citizens may not transfer capital anymore or that they have to bring their capital back, because they're still SA taxpayers or citizens. We don't foresee that scenario because that scenario will take us to a call it a Banana Republic and remember what the in global investor wants to see is that there's free flow of capital between borders. So they don't want to be limited in terms of the ability to invest in South Africa or to exit from South Africa. So our current view is that we don't expect any draconian aggressive capital controls, which will frighten foreign investors because the Reserve Bank and the Finance Minister understand our economic implications a lot more than people think and I trust their judgement to this point and so do the political and economic analysts that we subscribe to. So, we think that the capital controls will more or less be a local market.

Remember, if you take the numbers our debt is something like R4 trillion – the SA government debt, but just on corporate balance sheets in South Africa, the corporates, the banks etc sit with R2 trillion Rand in cash. Plus, if you look at pension funds like the government pension funds and all the pension funds that are administered in the industry, there's more than R2.4/R2.5 trillion in investment capital. So to support a three hundred billion or four hundred billion capital event with the right triggers locally where local companies or local pension funds may be indirectly forced to buy SA debt at an attractive yield… It will be market friendly, relative to capital controls on individuals and on foreign travel meaning capital travel in and out the country.

Niel Pretorius: Thanks Roeloff, just another thing. So we looked at the potential limits and the foreign investment allowance and the tightening of that by any chance, but when it comes to capital controls one of the effects it would have should they introduce this is that we then drop out of that JP Morgan local currency debt bond market because I think that's the only condition that they have is that you can't introduce capital controls.

Our leaders do understand that we need foreign capital.

RH: Correct, correct, well said very much so and we don't want that. We know and our leaders do understand that we need foreign capital and to make it market friendly, so it's unlikely for us to really enforce capital controls that becomes a Zim Armageddon scenario or anything like that.

MA:Just for our listeners, to paint some context, I think this has been an interesting conversation with Roeloff. It's something that we've been focusing on here at Sable and in discussions with Roeloff at Miton at the investment committee level. Because with our global living annuity, which is a South African living annuity that asset swaps into foreign funds, the portfolio that we and the series of portfolios that we build for South African resident clients is one that has the equity portion offshore and global and the fixed income portion in South Africa, using actively managed South African fixed income. And this portfolio tests incredibly well and has performed incredibly well against its peers and it seems to be sort of a dream portfolio, picking up all the equity performance offshore and the fixed income performance in South Africa that the offshore markets are now offering. Roeloff, do you have any thoughts on how that debt equity mix has worked in that particular portfolio?

RH:Mike I hate to say this but some of our SA investors are very jealous that they didn't have this portfolio for the last five years because local asset managers, us included, still believed that there could be some value in SA equities so, although we were very underweight SA equities, your portfolios outperform most of the other portfolios that we're responsible for just because of your mandate that you've given us and this investment committee to focus 100% on offshore equity and then to generate yield by using local assets or local yields and government and corporate yields. That strategy has worked and I can't see that change in the long term.

Forget South African economic conditions and the Rand. Forget all of that and just realise that our economy is less than 2% of the world.

Why do I say that? Forget South African economic conditions and the Rand. Forget all of that and just realise that our economy is less than 2% of the world. I think it's like 1.6% of the world out there, so the investment opportunity is definitely greater beyond our borders and that doesn't mean that we don't have good companies on our JSE. We've got the likes of Naspers and British American Tobacco, Anglo, Billies – all great quality companies that one can certainly still invest in, but they're all really global companies not local companies given that their revenue streams are more than 90% offshore and nothing to do with the SA economy.

So we feel like that's the appropriate solution for even our local investors now is to have very little SA equity exposure, although it's cheap, although it can recover locally, it's hard to see that at the moment. Global equity exposure for another reason and that is the low bond yields we face in government bonds globally and the low cash yields that those offer if any in the strong currencies. So investors need to realise that to be able to outperform inflation, whether it's global inflation or local inflation, to outperform cash which is now going to stay lower for longer due to the current scenario, you have to assume risk and therefore… companies and company management, their biggest mandate is to have profits for shareholders. Shareholders don't tolerate a company with a bad management or bad management decisions that generate losses infinitely. So good business models like the tech companies at the moment, some healthcare companies and even consumer discretionary stocks that face the global economy will do well because management is supposed to generate profit and earnings growth for shareholders. Therefore your expectation for offshore equities, even though it's a meagre 5 or 6 or 7% in Dollars, it's a lot more than having cash in the bank in Dollars at 0.5 or going to 0 in our opinion.

So in terms of a long-term portfolio, having a global equity portfolio that's actively managed by the likes of this committee, plus because you have liabilities and income that you want to serve in South Africa, with fixed interest yields where it is at the moment it's a very attractive combination. It's definitely a combination we prefer over the long term for clients. It doesn't mean that global equities or even local equities will become more volatile in the short front, because the markets have recovered well since the fear of the economic collapse in March. That said other than tech stocks the whole of the rest of the market's very attractively priced based on the fears of the economic woes, therefore it's safe if you take a long term view to have some offshore equity in your portfolio and then to have the benefit of real yields in South Africa servicing your income or your living annuity needs. It's a… I wouldn't say it's a match made in heaven but very close.

MA: Thanks Roeloff. There have been some really interesting insights. You know, we do get asked by clients who want to offshore their living annuities to go fully offshore – offshore bonds, offshore everything. Niel I know you gave a presentation a couple of months ago where you actually illustrated what happens to the volatility of that portfolio when you actually start avoiding SA assets completely and taking the SA fixed income part out. It's actually not a pretty picture.

Niel Pretorius: It's not. If you plot the volatility and if you just do the currency, if you forget about the fixed income if you just, let's say, I'm going to put it in cash and Dollars the volatility introduced before the offshore currency and the Rand, where you're trying to liability match, becomes so high you'd actually be better off sitting in a full equity portfolio because the currency volatility is higher than what the MSCI would be so it makes no sense just to go sit in that offshore currency even in a bond fund.

The highest risk asset class is Dollar cash in Rand terms.

RH: Niel as a team we so agree with you. We run an optimiser process where we look at the behaviour of the asset classes, its volatility and its relative application to each other to make an optimised portfolio in a perfect world and the most… if you want to know the asset class with the highest volatility, meaning looking at SA property, global property, SA equity global equity, bonds globally and bonds locally, the highest risk asset class is Dollar cash in Rand terms. So you're completely right. You're better off from a risk adjusted perspective, short and longer term, holding global equities relative to Dollar cash from a Rand perspective.

MA: Well Roeloff, it's been fantastic for you to spend your time with us. We think we've covered some really interesting topics there hopefully it's been good for our listeners to get some insight into the stuff that goes on in our investment committee and what we think about and the incredible contribution we get from Roeloff and his team at MitonOptimal, but I'm going to wrap it up there and say that's all from us today. Thank you all for your time and thank you for listening.

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That's all for this edition of the Wealthcast. If you have any questions or would like to know more about our financial services offering, you can get in touch by emailing wealth@sableinternational.com or leave a comment below. You can also contact Roeloff by emailing roeloff@mitonoptimal.com.