Crowding out. Two words that shouldn’t describe South Africa’s liquid and deep capital markets. But it’s becoming a real threat — to large corporates, at least.
Last year, several debt investors were quite hyped about the outlook for South Africa’s government bond market. Many predicted a handsome recovery in government bond prices (which would imply a drop in yields). But that optimism dissipated as the extent of South Africa’s economic woes became clear during the first half of this year.
For one, tax receipts didn’t live up to finance minister Enoch Godongwana’s optimistic expectations. In his February budget speech, he estimated a budget surplus of 4.3% of GDP. At the end of March, indications were that it had widened to 4.7%.
Underpinning this deterioration in tax income are struggling companies. Beset by hours of power blackouts, worsening security due to crime and increased finance charges (because of higher interest rates), profits are on the decline.
Financial results from large corporates such as Pick n Pay, Cashbuild, Italtile and Spar have already pointed to struggling consumers. A jump in credit loss ratios among the country’s largest lenders confirms that those who have credit are taking strain. And then there’s the slump in commodity prices, which will devastate mining profits, as well as subsequent income taxes.
Foreign investors have seemingly lost confidence in the government’s ability to kickstart the economy. That’s manifest in what Futuregrowth told clients last week is a ‘near multidecade low’ in the share of foreign holdings of local government bonds
So it’s little wonder that foreign investors have seemingly lost confidence in the government’s ability to kickstart the economy. That’s manifest in what Futuregrowth told clients last week is a “near multidecade low” in the share of foreign holdings of local government bonds, at 25.6%, as of July. A level that, it says, “will need to perk up to sustain a significant contraction in nominal bond yields from their prevailing highs”. Lower yields mean higher bond prices.
Why it matters is that an absence of foreign buyers means local investors are left to pick up bonds issued by other players — including corporates — who are being “crowded out” by a voracious government that has to borrow more money as tax receipts fall.
“You’re already seeing it,” says Nolan Wapenaar, co-chief investment officer at Anchor Capital. “You’ve [also] seen it in multiple other countries where the governments have mismanaged finances and as a result have seen interest rates increase to ridiculous levels to attract lenders.”
The consequence of crowding out, says Wapenaar, is that “corporates can’t necessarily afford current interest rates”, leaving them to issue only enough debt to refinance maturing bonds. It also raises the question of whether there is enough capacity in the local economy, with the dearth of foreign investors, to absorb the strong flow of issuances expected from the government.
According to Futuregrowth, “data for the month of June, historically a crucial month for corporate income tax receipts, confirmed our concerns about the knock-on effect of structural hurdles to economic activity, falling commodity prices and weaker global growth on tax revenue collections”.
Corporate income tax, which constitutes the largest source of tax revenue after personal income tax and value-added tax, “shrunk by 22% on a fiscal-year-to-date basis” compared with the same period a year earlier and is worse than the National Treasury’s forecast of a 1% decline, Futuregrowth says.
“The buoyancy in personal income tax has buffered some of this underperformance,” says Futuregrowth, “but the warning signs loom large for significant underperformance relative to estimates that the Treasury presented in the 2023 budget.”
Adam Furlan, portfolio manager at Ninety One, estimates the government is facing a R70bn shortfall in taxes this fiscal year — rising to as much as R90bn the year after.
According to Furlan, the government has a number of “levers” to address this year’s shortfall, such as tap its offshore issuance facilities, or use the cash buffers saved up over the past couple of years. There’s also the prospect of issuing inflation-linked bonds, especially as the R197 inflation-linker matures in December this year.
In the past the government has issued more debt on the long side of the curve — in other words bonds that have a duration of 10 years or more. But this tactic has become expensive, with investors willing to pay only between 70c and 80c for every R1 issued by the government. That means investors demand higher and higher yields to compensate for the risk they’re taking on when lending money to the government. It also means the Treasury receives less cash for the amount of debt it issues.
Last week, in a bid to start addressing cashflow, the Treasury increased its weekly short-dated debt sales, called treasury bills (T-bills), by about 19% to R2.3bn.
According to PSG Asset Management’s Lyle Sankar, that is not necessarily a bad thing. “Interest rates on shorter-dated debt are much lower than for long maturities. It is clear the budget office [at the Treasury] aims to address the government’s interest bill.”
By issuing more bonds on the short end of the yield curve (those instruments with a short maturity), the government taps into what Sankar describes as a still healthy demand from money market funds.
But Furlan warns that the local investment market is becoming “filled up with government bonds”. Many multi-asset funds have already switched to government bonds in a bid to lock in higher yields, at the expense of corporate bond issuances. With longer-dated government debt yielding in excess of 12%, many companies just can’t afford these kinds of interest rates, and will opt instead for bank funding.
With longer-dated government debt yielding in excess of 12%, many companies just can’t afford these kinds of interest rates, and will opt instead for bank funding
The Sabor rate, against which many corporate issuances are benchmarked, is about 8.209%, or lower than the South African Reserve Bank’s repo rate of 8.25%. Yields of 12%, which longer-dated government debt attracts, are far in excess of this. In comparison, government T-bills with a 91-day maturity are currently attracting tender rates of 8.38% — higher than what banks are charging each other to borrow.
Also, with yields at these levels, money managers demand higher margins above Sabor to compensate for the higher risk. Remember, government debt is viewed as the most secure type due to the issuer’s ability to print money.
“The spreads [on corporate bonds] are going lower and lower as the market is shrinking,” says Bronwyn Blood, fund manager at Granate Asset Management. “It’s the opposite of what is happening in the government bond market. There is complete crowding out of corporate bonds by government debt.”
Blood says the other problem is that corporates “aren’t investing — and hence not issuing debt”. This bodes ill for specialist money managers who opt only to invest in corporate debt.
For retail investors who cannot afford to buy government debt during the primary auctions or in the secondary market — in increments of R1m or above — there are several ways of including government bonds in your portfolio.
The National Treasury sells retail savings bonds directly and only to individuals. For the month of August, bonds with a maturity of two years attracted a fixed 9% yield, three-year bonds received 9.25% and five-year bonds 10.5%. (But as the interest earned on these bonds is taxed in the hands of an individual investor, careful planning needs to be done lest a nasty tax bill arrives.)
In addition, there are also several exchange traded funds (ETFs) that invest in government bonds — nominal as well as inflation-linked debt. Since the beginning of last year, CoreShares has launched two bond ETFs with one focusing on government debt and the other on nominal South African corporate and government bonds.
Finally, there are many unit trusts investing in the bond market. Most will hold both corporate and government debt.
— How to buy government bonds
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