In March, the All Bond Index was down 9.7%, inflation-linked bonds (ILBs) were down 7.1%, listed property was down 36.5%, preference shares were down 27.0% and the rand was down 12.3% against the US dollar. The magnitude of these moves has not been seen since the Global Financial Crisis (GFC) of 2008/2009 and importantly, have all occurred in a much shorter time period. During these periods of extreme risk aversion, there are two things that are guaranteed. Firstly, even if the entire portfolio could be converted to cash, the best one could expect is a return below that of cash. Secondly, during these times of indiscriminate risk sell-offs, any diversification in a portfolio does not work because all asset classes move in unison. Over the years, we have reiterated that, in order for the fund to be able to generate a return in excess of the risk-free rate, it needs to take an element of risk. Even though the fund was relatively conservatively positioned into the crisis, the magnitude of the moves in such a short period of time adversely affected performance. The fund returned -4.1% in March, bringing its total return to 2.0% for the 12-month period.
From mid-February 2020, the world experienced what can only be described as a near-cataclysmic shock. The double crisis of a global oil price war and the rapid spread of Covid-19 across continents has seen shockwaves of fear and panic penetrating geographical and generational boundaries.
No country has been insulated from this crisis, nor from the concurrent slowing in growth and economic uncertainty. The South African Reserve Bank (SARB) initially reacted by cutting interest rates by 100 basis points (bps), and in, subsequent days also unveiled an unprecedented number of measures to keep liquidity in the banking sector. These included offering long-term repurchase agreements (repos) of up to one year on government bonds; buying government bonds in the secondary market so as to support market liquidity; lowering certain regulatory bank capital ratios to support the economy and temporarily adjusting the funding mix in weekly government auctions towards shorter-dated government bonds. These measures helped calm the fixed income markets somewhat, but the downward adjustment in asset prices was already quite severe. After the lockdown was extended at the start of the Easter weekend, the SARB announced a further 100bps emergency rate cut as the severe economic impact of the sudden stop in the economy became clearer.
John F. Kennedy once reflected, “When written in Chinese, the word ‘crisis’ is composed of two characters. One represents danger and the other represents opportunity.” We believe this observation holds true for this crisis as well. In assessing it, we need to both ascertain the short-term economic consequences that will manifest over the coming months and identify those investment opportunities that could benefit our client portfolios over the next five to 10 years. Coronation’s bottom-up, valuation-driven research process aims to identify those assets that are mispriced for the underlying risks and that have a sufficient margin of safety. In the context of South African fixed income assets, we have reassessed our fundamental assumptions coming into this crisis in terms of what the unfolding situation means for these assumptions, how this filters into our asset valuations, and, finally, how we position the portfolio in response to these changes.
THE ONSET OF CONTAGION
Prior to Covid-19, our key assumptions were that inflation in South Africa would remain under control (5% average), growth would remain subdued (0.2% for 2020 and 1.1% for 2021) and that government finances would remain constrained, but the problems were being adequately addressed. We had expected interest rates to move lower by between 50bps and 75bps in order to provide some offset to fiscal tightening and to lend support to growth. Against this backdrop, we viewed nominal government bonds as attractive, specifically in the longer end of the curve; ILBs in the two- to five-year area were offering good value relative to nominal bonds and cash; and certain counters within the listed property space seemed reasonably attractive. We were very cautious on corporate credit, as we did not believe that valuations accurately reflected the higher risks associated with slowing growth. Credit spreads compressed aggressively over the past 18 months due to a reduction in supply and a reach for yield by non-traditional credit investors. In our view, this made the asset class very expensive, and hence unattractive. Therefore, our portfolios had a neutral allocation to government bonds (with duration focused in the longer end of the curve), a moderate allocation to ILBs, a historically low allocation to selected listed property stocks and a low allocation to select corporate credit.
UNDERSTANDING THE IMPACT OF COVID-19
The Covid-19 crisis has been likened to the Great Depression of the 1930s, due to the expected effects on global growth. Global GDP declined by 27% during the course of the Great Depression, which lasted just under four years. Global growth is expected to decline by a similar magnitude in the second quarter of this year alone. It is the stimulus measures taken by governments around the world to mitigate the impact of the virus that have caused turmoil in financial markets, as they try to assess the economic consequences of such actions. One of the big teachings for authorities from the Great Depression and the GFC is the need to act quickly, lest markets lose confidence and the crisis blows up. Global authorities have responded very quickly by dropping interest rates back to zero and committing to large quantitative easing (QE) measures (much greater than those seen in the GFC). In addition, many developed markets have already committed to fiscal spending ranging anywhere from 2% to 10% of GDP, in order to soften the growth slowdown and foster a stronger subsequent recovery.
SOUTH AFRICAN GOVERNMENT BOND MARKET LIQUIDITY DRIES UP
Local assets reacted in lockstep with the global risk aversion sell-off. However, South African government bonds (SAGBs) have been exceptionally volatile during this period and sold off materially. Next to cash, government bonds are the most liquid part of a portfolio. In times of crises, when cash is often required to meet margin calls on less liquid assets and to satisfy redemptions, government bonds are used as the natural funding source. The aggressiveness of the sell-off in global risk markets and the outflows globally from emerging market bond funds have meant that foreign investors into the local bond market have had to sell their holdings for this exact purpose. This created the first leg of the sell-off in our bond market. In addition, we saw the liquidity in the interbank market evaporate, as local banks (the sole intermediaries of SAGBs) pulled back on risk-taking due to reduced liquidity conditions. In times like these, banks prefer to limit the cash lent in the interbank market and utilised in trading activities in financial markets, primarily to support their corporate and individual customers who may have funding and operational needs. This propagated the irrational market behaviour we have witnessed over the past few weeks. The SARB played a crucial role by stepping in and injecting liquidity into the market, restoring some calm. This included offering term repos on SAGBs and buying SAGBs in the secondary market.
MOODY’S DOWNGRADE TO SUBINVESTMENT GRADE
Moody’s Investor Service downgraded South Africa to subinvestment grade on 27 March 2020, a day after we went into lockdown. This is not a new development and had been well flagged by the market for a few years. As suggested in previous articles, offshore investors have been decreasing their holdings of SAGBs for some time now, and the South African sovereign spread already trades at levels consistent with subinvestment-grade debt. Additionally, we have seen the South African risk premium steadily increase, suggesting that even before the onset of Covid-19, the downgrade was already significantly priced in. The one thing that has changed is that market volatility has increased and liquidity in the secondary bond market has decreased. This suggests that the mandated selling of SAGBs might result in a more significant move than initially anticipated. However, the FTSE, which administers the World Government Bond Index (WGBI), has allowed up to the end of April for funds to rebalance, which won’t stop the selling but will allow it to be more gradual (previously, funds would have had to rebalance by the end of March). In addition, with the SARB announcing its willingness to purchase SAGBs in the secondary market, the effect of this will be dampened. The more important question is whether this weakness represents a great buying opportunity, or whether fundamentals have shifted to such an extent that a more significant risk premium for SAGBs is justified.
CHANGES TO FUNDAMENTALS
The Covid-19 crisis is still evolving, with many unknowns. Key is the length of time that nations will remain in lockdown and the subsequent economic disruption. This uncertainty is clear in market volatility and the decline in risk appetite. However, there are a few key conclusions that we can draw at this point. First, inflation and growth will be lower than our previous expectations. We expect inflation to average below 4% in South Africa over the next two years. This is due to the impact of the slowdown linked to Covid-19 and the lower oil price. Growth in 2020 is likely to be anywhere from -4% to -7%, rebounding to just over 3% in 2021. This is why the SARB has already cut rates by 225bps this year, moving policy rates lower to 4.25%. This reduced the real yield on cash materially but still kept it in positive territory, which still compares favourably to the negative policy rates prevalent in most of the global developed economies. Unfortunately, given South Africa’s poor fiscal starting point and now negative growth expectations, it is very likely that the debt-to-GDP ratio will increase towards 80% and the fiscal deficit will widen to between -8% and -10% of GDP. Further compounding this problem will be the need for government to provide more fiscal support to aid the economy through these trying times, and any additional support for ailing State-owned enterprises (SOEs) such as Eskom. On the positive side, however, lower growth implies lower energy intensity, giving Eskom time to deal with much-needed maintenance. We are hopeful that this situation allows for more drastic measures to be taken at Eskom in order to rectify its financial and operational position.
In many historical instances, crises are what necessitate change. South Africa has been plagued with a slow policy response to its many structural issues. However, the pragmatic approach to the recent crisis will hold our political leaders in high esteem when we finally emerge from it. In an uncertain world, and in an economy that has lost all hope, if the leadership uses this crisis to make the necessary hard decisions, the country could very likely emerge stronger post-Covid-19. However, as investors, we cannot bank on hope and must instead ensure that we position our clients’ portfolios for the risks and opportunities that are arising.
THE VALUATION OF SOUTH AFRICAN GOVERNMENT BONDS REMAINS ATTRACTIVE
10-year SAGBs currently trade at a yield of 11% compared to cash, which we expect to be around 4.25% by the end of this year. The spread between SAGBs and cash is at the widest it has been since the start of inflation targeting (2001) and implies that 10-year SAGBs can sell-off by 100bps over the next year before they start to underperform cash. In addition, with inflation expected to average close to 4% over the next two years, the implied real yield on the 10-year SAGB is close to 7%.
Global policy rates have moved to zero and are expected to remain there for some time to come. As mentioned, developed market central banks have restarted their QE programmes on a scale larger than those implemented during the GFC, and the level of monetary policy accommodation and support that has been pushed into the global economy is unprecedented. Global developed market bonds either trade in deeply negative territory or very close to zero. 10-year SAGBs now trade in excess of 10% above developed market bonds.
Emerging market local currency bonds have all moved weaker during the crisis, but South Africa remains the cheapest real yield and the cheapest tradeable nominal yield among its peers (Table 1)
The SARB’s commitment to keep liquidity in the system and the National Treasury’s adjustment to the funding profile over this period have seen the yield curve flatten quite aggressively past 20-year maturity Figure 3). In running our total return calculations, we believe that bonds in the 10- to 12-year bucket offer the most value. Table 2 shows how much bonds can sell off before their return equals that of the ALBI, and how much they can sell off before they can match the return of 10-year SAGBs.
Globally, credit spreads have blown out. South Africa’s sovereign credit spread was already trading at a level consistent with other subinvestment grade countries, but is now trading 100bps wider than even the Subinvestment Grade Index, as shown in Figure 4. Even if one assumes this is correct, the absolute level of sovereign credit spreads is very much elevated, suggesting potential room for compression.
In constructing a fair value estimate for 10-year SAGBs, we use the global risk-free rate (the US 10-year Treasury Bond), the inflation differential between South Africa and the US, and the South African sovereign credit spread. In Table 3, both based off current market variables and expected values for those variables, we believe 10-year SAGBs are trading at levels 120bps to 220bps above fair value. This is just one of the many models we use to determine the fair value for the 10-year SAGB, but it is the simplest and easiest to understand.
FIVE- AND 10-YEAR INFLATION-LINKED BONDS ARE ATTRACTIVE
ILBs have sold off, both in sympathy with nominal bonds and due to lower inflation expectations. However, given the higher modified duration of most of these bonds, they have underperformed their nominal counterparts. In Table 4, we list a few key ILBs, their current real yield, and their implied breakeven (where inflation has to average in order for their return to equal that of the nominal bond equivalent). In five- and 10-year ILBs, real yields are close to 6%, with breakeven inflation well below 5%. We consider these to be very attractive and they warrant a healthy allocation in our portfolios.
OUR BIGGEST CONCERN IS THE LOCAL CREDIT MARKET
Fundamentally, we believe that South African corporate credit spreads should already have been under pressure, given the poor economic fundamentals of the country and the clear evidence that the probability of default for most borrowers is on the rise. A clear indication of this was shown in the rising credit loss ratios reported by all our local banks during their last updates. However, there has been a drop in corporate issuance due to the poor growth backdrop and the lack of the funding needed by banks and corporates (due to the lack of investment in the country). Leading into the crisis, with issuance lower and a reach for yield in the local market spurred by the reduction in the return expectations of many other asset classes, local credit spreads compressed aggressively. The economic fallout of the Covid-19 crisis will add further stress to balance sheets of South African companies, hence lowering their credit quality. As such, it is reasonable to expect a widening of credit spreads just based on the fundamental deterioration. Add to this the repricing we are seeing in global credit markets, the drop in risk appetite, an acceleration of redemptions from fixed income funds in lieu of cash and a tightening of credit spreads over the last 12 months, and one can easily see that this is a market that needs sobering.
Coronation’s bottom-up, valuation-driven credit research process takes both fundamentals and liquidity into consideration in its assessment of risk and return. This ensures that we build a level of conservatism into our pricing expectations to deal with the illiquid nature of certain assets. In addition, liquidity plays a vital role in our portfolio construction process. Over the last 18 months, we have endeavoured to reduce our exposure to listed credit by reducing our exposure to new-style bank subordinate debt (AT1 and AT2), certain bank senior issues and not actively purchasing new issues in the primary market. Our current holdings of credit instruments are shorter dated in nature, predominantly issued by the big four banks and are listed on the JSE, making them tradeable in some part.
Globally, credit spreads have widened tremendously, as have the credit spreads of South African companies that issue offshore debt.. The Sasol two-year bond trades at a yield of 22% in US dollars, and Standard Bank and First Rand Limited Tier 2 sub-debt bonds now trade at yields of 10% in US dollars. In the local market, however, these bonds have not re-marked at all, with Sasol two-year debt still marked at 134bps over Jibar (6.8% all-in yield) and the banks’ four-year sub debt still marked at 250bps over Jibar (8.1% all-in yield).
These bonds are generally illiquid and are held by local institutions. We expect them to only re-mark in the secondary market when they are sold. We view it as just a matter of time before we see a significant re-mark in these debt instruments as redemptions intensify and forced selling pushes spreads to levels like those seen in the offshore market.
At the end of February, shorter-dated fixed-rate negotiable certificates of deposit (NCDs) traded at 6.89% (three-year) and 8.25% (five year). Shorter-dated NCDs have pulled lower due to the significant cut in interest rates by the SARB, while the five-year levels have pushed wider, due to the widening in credit spreads and sell-off in bond yields. The spreads of floating-rate NCDs have been unappealing to the fund over the last few quarters. Covid-19 will place the economy under severe pressure, leading to a broad-based deterioration in credit quality. In addition, interbank liquidity has reduced significantly, which has resulted in significant movements in bank NCD floating rate spreads. The entire curve has shifted wider by between 35bps and 45bps, putting five-year floating rate NCDs at 3mJ+150bps and one-year floating rate NCDs at three-month Jibar+112bps. Short-dated fixed-rate NCDs continue to hold appeal due to the inherent protection offered by their yields and relative to our expectations for a lower repo rate. In addition, NCDs have the added benefit of being liquid, thus aligning the liquidity of the fund with the needs of its investors. Longer-dated NCDs, although at fairly extended levels, are still at risk of further widening, which keeps the fund cautious in adding them to the portfolio.
LISTED PROPERTY LOOKS CHEAP AT FACE VALUE, BUT YOU NEED TO LOOK UNDER THE HOOD
The local listed property sector was down 36.5% in March, bringing its return for the rolling 12-month period to -48.1%. Listed property has been the largest drag on the fund’s performance, despite a low allocation of 3.2% at the start of the quarter. The local listed property sector has grown tremendously over the last 10 years into a meaningful part of financial markets, with a market capitalisation of almost R300 billion. However, not all listed property companies are the same. Each one has varying exposure to different sectors (retail, office and industrial), varying underlying asset quality and varying financial constraints. In the last five years, many have chosen to diversify away from South Africa and enter highly leveraged plays on offshore property. This has resulted in a general rise in balance sheet risk across the sector. The current crisis will reduce rental income, put pressure on asset values, increase the cost of borrowing for lower-quality businesses and test inexperienced management teams. It is entirely possible that most of the companies will require additional capital and that dividends are suspended to preserve capital. Currently, dividend yields are eye-watering, touching close to 30% in some of the large-cap names. However, one must be cautious not to take these at face value and understand how the key issues mentioned above affect that yield. Dividends could be suspended and a 30% historic yield could become zero one year out. We believe there are a few select large-cap counters that satisfy our stringent conditionality. These include Growthpoint, Liberty Two Degrees and Redefine. These are all counters in which we currently have holdings across our multi-asset funds and in which we would take more meaningful stakes in time to come.
The FTSE/JSE Preference Share Index was down 27.0% over March, bringing its 12-month return to
-22.3%. The change in capital structure requirements mandated by Basel III will discourage banks from issuing preference shares. This will limit availability. Despite attractive valuations, this asset class will continue to dissipate, given the lack of new issuance and because it risks being classified as eligible loss-absorbing capital (only senior to equity). Over the month, we have seen a significant reprice in instruments that rank equivalent to preference shares in their capital structure, suggesting there might be further downside for this illiquid asset class. The fund maintains select exposure to certain high-quality corporate preference shares, but will not actively look to increase its holdings.
POSITIONING OF THE PORTFOLIO: CAUTIOUS AND VIGILANT
We view 10-year SAGBs as the most attractive asset in the fixed income universe, with five- to -10-year ILBs coming in a close second. Listed property looks attractive, but allocations need to be made on a stock-specific basis, with careful consideration paid to the issues outlined above. Local credit markets are very unattractive, and we would wait for a significant widening in credit spreads before allocating more capital. We will instead use the little credit that we have, given that it is shorter dated, as a funding source for the other more attractive asset classes.
We remain vigilant of risks emanating from the dislocations between stretched valuations and the underlying fundamentals of the local economy. However, we believe that the fund’s current positioning correctly reflects appropriate levels of caution. The fund’s yield of 9.08% remains attractive relative to its duration risk. We continue to believe that this yield is an adequate proxy for expected fund performance over the next 12 months.
We remain committed to only adding assets to our clients’ portfolios that we believe offer a sufficient margin of safety and are adequately priced for the underlying risk. We are constantly on the prowl for valuation dislocations relative to fundamentals, which we believe will benefit our client portfolios over the longer term. In this volatile period, asset price behavior tends to be irrational, which will adversely affect short-term performance. It is during times like this that once-in-a-lifetime opportunities present themselves, and one has to stand ready to act with conviction in order to take advantage of these opportunities.
As is evident, we remain cautious in our management of the fund. We continue to invest only in assets and instruments that we believe have the correct risk and term premium to limit investor downside and enhance yield.