Bond Outlook

The memorandum of understanding between the US and Iran unravelled in early July amid renewed military strikes and attacks on commercial shipping and expired in August without a durable settlement. Consequently, Brent crude reversed much of its second quarter (Q2-26) decline, rising by about 42%. It briefly exceeded US$107 in September as Strait of Hormuz disruptions were compounded by attacks affecting Saudi Arabia’s alternative Red Sea export route.

However, by the end of the third quarter of the year (Q3-26), Middle Eastern exports had nearly recovered to pre-war levels, but negotiations remained unresolved. The risk of a sustained US$100-plus oil price and the associated global inflation- and interest-rate consequences therefore re-emerged as a central vulnerability for the macroeconomic outlook. Global bond markets have been (and continue to be) tormented by a combination of higher policy rate expectations and a higher global risk free rate, as the US 10-year bond pushed emphatically through the psychological 5% level. This has deflated sentiment as risk assets remain on the backfoot, heading into the final quarter of the year.

South African (SA) assets proved more resilient than they were during the initial shock in the first quarter of the year, although nominal bonds surrendered part of their strong Q2-26 recovery. The rand traded in a wide range of approximately R16.05-R16.98/US$ before ending September near R16.42/US$, broadly unchanged from the previous quarter. The 10-year SA government bond (SAGB) yield increased by c. 50 basis points (bps), to c. 9% at the end of September, as higher oil prices, rising global yields and renewed inflation concerns weighed on duration. The FTSE/JSE All Bond Index (ALBI) was down 0.68% for the quarter, behind cash at 1.69% and inflation-linked bonds (ILBs) at 1.45%. The weakness was concentrated at the longer end of the nominal curve, with bonds in the seven- to 12-year and 12-year+ sectors returning -0.71% and -1.47%, respectively. Over 12 months, the ALBI returned 12.82%, compared with 6.76% from cash, and 15.45% from ILBs. Year to date, ILBs have retained their defensive advantage, returning 6.81% versus 4.99% from cash and 3.54% from nominal bonds. Despite the poor short-term performance of the local bond market, it remains well ahead of global bonds, which have widened significantly. This is evidenced by US 10-year bond yields, which are 100bps higher than at the start of the year, and many other developed market bond yields that are 50bps-100bps higher since the start of the year.

TWO QUARTERS INTO CONFLICT

In March of this year, when the Middle East conflict reignited, SA’s inflation was 3% and the nominal repo was 6.75%, placing the real repo rate well into restrictive territory. This provided a robust departure point from which SA’s monetary policy could navigate the precarious landscape. Since then, inflation has averaged well above 4%, necessitating two 25bps rate hikes by the South African Reserve Bank (SARB) to dampen possible second round effects. Our updated forecasts, which incorporate a higher-for-longer oil price and higher food prices due to the El Niño effect in 2026/2027, now see inflation averaging 4.4% in 2026 and 2027. We expect it to peak well above 5% in the first quarter of 2027, before returning to a 3.5% average in 2028. This might necessitate a further increase in the repo rate by the SARB, however due to the “stagnationary” impact of the oil price shock, we believe that it would be reluctant to deliver a further three rate hikes as the market is currently pricing (Figure 1). The outlook for the oil price remains uncertain, with risks symmetrical for inflation from here on. However, growth risks are asymmetrically to the downside, having already been revised down for this year and the next. This will weigh on the SARB’s decision going forward, especially as the commodity boom starts to fade and the local growth engine remains sluggish. A reduction in monetary policy rate expectations could thus be a tailwind for bond performance.

One of the benefits of the Middle East crisis and dollar debasement has been a boost to precious metals and, thus, an increase in SA’s terms of trade. This is generally a short-term phenomenon, however the magnitude of the move has provided a profound boost to fiscal revenues. National Treasury has remained restrained on the spending front and committed to fiscal consolidation, which has helped stabilise the deficits and debt load. We should continue to see some improvement in the fiscal dynamics over the next 18-24 months, as the budget deficit moves below 4% and debt stabilises below 80% of GDP. Treasury has also made great strides in reducing borrowing costs by diversifying into alternate borrowing pools and reducing their reliance on fixed rate bond issuance. The combination of this and better fiscal outcomes has allowed them to reduce their issuance in fixed nominal bonds, helping support the compression in bond yields and reducing SA’s debt service cost. In addition, as bonds have rallied, the discount at which Treasury issues bonds at the weekly auction has also reduced, thus creating a self-reinforcing cycle of better borrowing outcomes.

These developments have been well received and alleviate pressure on government finances in the short term. Unfortunately, SA’s debt load still remains high and in order to see metrics progress towards investment grade norms, growth needs to be much higher than the current 1.5-2% projections over the medium term. Growth needs to be in excess of 3% for a meaningful period, to see a significant improvement in debt metrics. This, as we know, can only be achieved through substantial reforms in network industries, governance, service delivery, ease of doing business, and the security cluster. As such, although we remain positive on fiscal developments in the short term, we remain reluctant to build these into our long-term expectation for SA’s government finances.

HAVE WE PEAKED?

SA nominal bonds have enjoyed an enchanting period of high returns. The ALBI has delivered returns that have outstripped cash by more than 5% over the last five years and 3.5% over the last 10 years, with the absolute numbers in low double digits. Yields have compressed c. 300bps in the three years from levels of c. 12%. With bond yields currently sitting at 9% versus cash at c. 7%, the question on most investors’ minds would be: can the party continue?

Instead of opining on how fundamentals can evolve to further support the superior performance from SA nominal bonds, we looked at historical episodes when the SA 10-year bond was in the following ranges: 1) 6.75-7.25%, 2) 7.5-7.75%, and 3) 8-8.25%. We then looked at where the yield curve was in those ranges and take the average of those values. This provides a picture of how the yield curve behaved when the SA 10-year bond reached those various levels (Figure 2). The principal observation from this exercise is that the move lower in yields is driven by lower front-end rates (policy rates anchoring the curve lower) and, as a result, the curve bull steepens (shorter maturity bond yields compress more than longer maturity bond yields).

The next thing to do is to look at what the performance of the ALBI would be over the next three years if the current curve converges with historic yield curve levels when the 10-year bonds were in each of the defined ranges, and which bonds were the best performing. In Figure 3, we can see in all cases the ALBI would deliver returns in excess of 10%, driven by the performance of bonds with a maturity of greater than 12 years. Drilling further into the buckets, in all three scenarios, the 15-year bond delivers the best return (14.2%, 12.7% and 11.7%) which is well in excess of ALBI returns. The key reason for this is that although the 15-year bond yield does not compress more than shorter-dated bond yields, it carries a much higher modified duration (sensitivity to interest rate or yield movements), which compensates the investor handsomely. In the table below, there is a 4^th scenario added for completeness that looks at the total return expected from the ALBI if yields stay constant at ~9% in the 10-year area. As one might expect, the return materialises at 9% and the 15-year point (being the highest yielding point on the yield curve) once again generates higher a return in the 12-year+ bucket (9.9%).

The conclusion from this analysis is that if nothing changes or bonds continue to rally towards historical lows, the good times can keep on rolling. However, given all the good news that SA has had thus far (better fiscal outcome, lower inflation targeting, and coalition government), what more needs to go right?

We now look at some of the key economic indicators when these lower bond yields were achieved and compare them to current. Figure 4 lists the average of each of the indicators for the various bond ranges versus where those indicators currently are. One could argue that the progress made on lowering inflation has been the key reason why bond yields have tracked lower. However, in order to see yields sustain a move to much lower levels we need a combination of 1) the repo rate moving materially lower, 2) GDP growth exceeding 2%, and 3) much lower debt to GDP. The repo rate might move lower as the oil price recedes, but higher growth and lower debt will take much longer to achieve, making a material rally in bonds from current levels unlikely given our current three year outlook.

However, SA nominal bonds are still set to deliver returns in excess of cash if nothing changes (9%). It may be even more if the oil price returns to lower levels as pressure in the Middle East fades, still making them an attractive holding in a portfolio. ILBs have served their defensive purpose in portfolios, and, given their current valuation, still suggest some upside, albeit this has reduced significantly. At current levels, if inflation materialises at 4.4% over the next year, the front end of the ILB curve (given market implied breakevens are below 4.4%), still offers a pickup relative to the equivalent nominal bonds (Figure 5). This validates their position in bond portfolios as a defensive alternative.

In order to complete the analysis, we applied our nominal bond analysis to ILBs. This time, we look at how the ILB curve behaved when the nominal 10-year bond moved into the defined ranges. However, the key issue with the analysis is that inflation over all of those periods was closer to 6%. This means the market implied breakevens (market’s expectation for inflation) were either at or above 6%. This is a stark contrast to our current standpoint, as inflation is much lower and expected to return to below 4% over the next three years. We therefore adjusted our analysis so that real yields reflect a 4% breakeven inflation expectation. The results are intuitive given the lower breakeven inflation, that is, ILBs produce lower returns than nominal bonds (Figure 6). Therefore, although ILBs currently offer value over the next year versus our inflation expectations, in the event that expectations shift towards a more material move lower in nominal bond yields due to a change in economic expectations around growth and debt, portfolios should concentrate exposure in nominal bonds.

CHANGE YOUR EXPECTATIONS

The quarter under review has served as a reminder that SA bonds do not operate in a vacuum: the renewed oil shock, a US 10-year yield above 5%, and a repricing of SARB expectations were enough to erase part of the Q2-26 recovery, despite improving domestic fundamentals. Yet, the starting point remains attractive. At a 10-year yield of c. 9%, nominal bonds offer a real yield of close to 4.5% against our medium-term inflation forecast and a carry of c. 200bps over cash, with risks tilted more towards lower policy rates than current market pricing. Our scenario analysis shows that the ALBI should deliver returns in excess of cash even if the curve does not move; and double-digit returns if yields converge towards historical levels, with the 12- to 15-year area of the curve offering the best risk-adjusted outcome. A material rally beyond current levels, however, would require more than the good news already in the price: it needs a sustained reduction in the repo rate, growth above 2% and a visible decline in the debt burden. Only the first of these is plausible within our three-year horizon.

We therefore position portfolios with a core overweight in nominal bonds concentrated in the 12- to 15-year sector, maintain a front-end allocation to ILBs as a defensive hedge against a prolonged oil shock while breakevens sit below our 4.4% inflation forecast, and stand ready to rotate from ILBs into nominals should the growth and fiscal narrative improve enough to justify a structural move lower in yields. The party may not be over but, from here, investors should expect to be paid for carry and duration rather than for a repeat of the past three years' capital gains.

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