South African bonds not presenting value at current prices Published October 30, 2013 | By Maya Fisher-French BondsAlthough South African government bonds are less expensive than they were a few months ago, they remain overpriced and continue to offer little value to investors. This is according to value-based asset manager, RECM, which says that despite the recent sell-off following concerns over the US tapering its quantitative easing (QE) programme, local government bond yields are currently still depressed. Sean Neethling, Credit Analyst at RECM, says that as a result of stimulus programmes, foreign investors have distorted the market and asset prices have been inflated by artificial demand. He says that as a result, valuations are still stretched, despite observing some convergence between price and value as the local bond market starts to re-price itself. He explains that the anticipation of the Fed tapering has increased global bond market volatility, especially in emerging market economies like South Africa, which are heavily reliant on foreign capital inflows to plug large current account deficits. “Foreigners make up around a third of the local government bond market, so the country is particularly exposed to a change in investor sentiment or appetite for holding our bonds.” Neethling says that the bond market has probably reached a tipping point in the cycle. “It is not sustainable to have central banks injecting excess liquidity into financial markets and anchoring longer-term rates. QE was not implemented as a permanent policy tool by central banks – the stimulus was only intended to kickstart the US economy by encouraging bank lending and consumer spending. The selloff in bond markets earlier this year can effectively be viewed as a dress rehearsal for when stimulus is scaled back and eventually concluded.” He says that both the timing and size of any tapering is not a consideration in RECM’s valuation of the market. “According to our valuations, even at 8%, the yield on a ten-year government bond is providing a real yield of only 2%. The average real return on a ten-year bond in South Africa has been around 3% after adjusting for inflation at around 5.9% since 2000. “By simply using this average as our expectation of future inflation, we would require a nominal yield of around 9% on a ten-year bond to consider it fairly priced. Theoretically, shorter-maturity bonds are less risky because of lower duration but are more exposed to interest rate volatility, so based on our research these bonds are also trading above our fair value estimates.” The corporate bond market – also not offering much value Neethling says that the corporate bond market also saw record issuance in 2012 and the tightening of credit spreads priced off record low ‘risk-free’ government bond rates, has made it difficult for investors to find value in the current economic environment. “Valuations in the corporate bond market are also expensive, as investors have moved further down the credit curve to higher-risk corporate issuers. Higher-quality issues are regularly oversubscribed with spreads being compressed on the back of strong investor demand. Searching for yield in corporate bonds may offer better relative value by providing a yield pickup over government bonds, but the additional yield is largely to compensate investors for the higher credit risk. “This is especially important in SA where corporate bond markets are not as deep and liquid as in developed countries, and investing purely for yield could expose investors to a permanent loss of capital.” He explains that this was evident with First Strut, the first listed corporate default in South Africa, which issued R925m as part of its listed debt programme. The company filed for provisional liquidation in July after it was unable to repay its debt obligations and ended up defaulting on its bonds. “RECM did not have any exposure to the company. The credit was priced too tightly in our opinion, and based on the fundamentals of the business, we were not being adequately compensated for taking on the credit risk. That being said, it’s near impossible to protect against the reported levels of fraud which ultimately culminated in the collapse of Firststrut, as investors are reliant on accurate reporting for both due diligence and risk management processes. Neethling says that RECM mitigates credit risk by investing in understandable businesses at an appropriate margin of safety and ensuring adequate covenant or collateral cover for lower rated companies. ‘’We use external credit ratings as a screen in our process, but expected returns are based on bottom up fundamental analysis which consider the ability of a company to service its debt obligations over the full life of a bond. “Generally with bonds, what you see is what you get. For example, if a bond is paying an 8% yield, that is what an investor can expect to earn on holding the bond to maturity. It is less about picking the winners and more about avoiding the losers, or those companies that have a higher probability of defaulting over the term of the bond.” “As bottom-up value investors, RECM look at absolute value across all asset classes and are therefore still not seeing much value in bonds at present. We do not believe that the bond market has normalised sufficiently to be considered fairly priced. We have a preference for investing in high-quality businesses with strong barriers to entry that are trading at a discount to our estimate of intrinsic or fair value.” He says that the decision to not actively participate in bond markets at this point of the cycle is a choice they are conscious of in protecting investors’ capital. “We are not certain as to when bond markets will normalise, but we have seen how quickly these market distortions can unwind. From our perspective, we are not forced buyers of bonds and are therefore patient in waiting for attractive buying opportunities to arise in future,” concludes Neethling.
Posted on: Thu, 07 Nov 2013 13:41:35 +0000
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