Risks loom for South Africa’s bond rally

July 23, 2012

Investors are wondering how much longer the rally in South Africa’s local bond markets will last.

The market has received inflows of over $7.5 billion year-to-date, having benefited hugely from Citi’s April announcement that it would include South Africa in its elite World Government Bond Index (WGBI).  But like many other emerging markets, South Africa has also gained from international investors’ hunger for higher-yielding bonds. And the central bank’s surprise rate cut last week was the icing on the cake, sending 5-year yields plunging another 30 basis points.

There are some headwinds however. First positioning. Around a third of government bonds are already estimated to be in foreigners’ hands. Second, markets may be pricing in too much policy easing (Forward rate agreements are assigning a 77  percent probability of another 50 bps rate cut within the next six months).  That’s especially so given local wheat and maize prices have been hitting record highs in recent weeks.

For these reasons, UBS analysts say it is time to book profits.  They note that the 2026 bond they recommended buying on June 15 has already rallied more than 100 bps.  Analysts at the bank write:

We did not anticipate the global grab for duration to be as intense as it has been. Yields have come in a lot and we think it is now time to get out of this trade.

And despite falling long-dated yields, most of the bond rally has actually been concentrated in short-dated paper, meaning South Africa’s yield curve is among the steepest in emerging markets. That, according to UBS analysts, is a reflection of the country’s longer-term fiscal and trade deficits and the likelihood of more bond issuance in coming years.

There is also the currency risk. The rand tends to react fast to risk negative news and unlike the Turkish lira, is not actively supported by the central bank.  Expectation of more rate cuts will likely weigh on the currency.

Barclays remain overweight South African bonds, predicting the curve will continue to flatten as investors push out exposure to longer-dated bonds. But they reckon the rand will not benefit from the huge bond market flows because of investors’ inclination to hedge the currency risk.

And the sharp recent yield falls are amplifying this risk —  according to UBS,  yield to maturity on the 2015 bond is now lower than the cost of hedging rand exposure.

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