Andrew Canter: $1.25bn Eurobond shows SA is already being treated like a “junk” borrower

Futuregrowth’s CIO Andrew Canter looks at the pricing of SA’s $1.25bn Eurobond finalised this week and looks at the implications of the downgrade to “junk” status. He explains how the interest rate paid on the Eurobond was one percentage point higher that an “investment grade” rated nation would pay, showing investors are already discounting a downgrade to “junk” status. He urges caution: “We’re living in a period of political uncertainty, therefore also economic uncertainty”. So what to watch out for in future, and how would bond market vigilantes react if one of either President Jacob Zuma or Finance Minister Pravin Gordhan to leave the stage? Canter likes short-dated inflation linked bonds – and explains to’s Alec Hogg why.

This special podcast is brought to you by Futuregrowth whose chief investment officer, Andrew Canter joins us now, Andrew, interesting discussion that’s going on at the moment about the potential downgrade of South Africa’s sovereign status. We’ve had updates in that regard but I’d love to start off with this Eurobond that South Africa has just placed in the global markets and if you could just maybe unpack it for us. On the level of the rating it does appear that we’ve paid up a bit more than in the past.

Probably speaking, the whole talk of the market, the world around South Africa has been downgrade, downgrade, downgrade and I think by and large that has been in our sovereign spreads for the last couple of months since Nenegate in December, so South Africa is already priced like a double B credit while we are technically still a triple B issuer in the world.

Explain the difference between the two, triple B, and double B?

When we’re talking about credit ratings, as you know they go from a scale from triple A which is basically very low risk, very high quality all the way down to double A, single A, triple B, double B and so on down to D for default. Once you’re below what’s called triple B you are called sub-investment grade or junk debt. South Africa is flirting with that now. We are in the triple B space but all three major global ratings agencies but the outlooks are negative and because of the degrading fiscal situation in South Africa and the low growth outlook and policy uncertainty, the expectation is that the static emperors and the fiction. The Moody’s of the world are looking to downgrade South Africa possibly below the triple B level into the junk debt territory.

As an indication though the Eurobond that was now placed, would that have put us in the triple B, in other words in the investment grade rating which we officially hold at the moment or is it in line with what a double B would expect?

As I said, we have been for the last couple of months and on this bond as well, been pricing as if we were a double B asset or put differently the spread on our international bonds is the same as other countries that are already rated double B. In that regard we would talk about a downgrade and what does it mean? The answer is it’s already in the price. The answer is, from an international pricing of our cost of capital as a country, the country is already being and paying up as if it were a double B rated entity.

Read also: Rand tumbles as Zuma wins stay of execution – downgrade worries persist

What is the difference, particularly, because it’s a good example now to use this 1.25 bn Dollar/Euro bond, what would South Africa have paid if it were rated as a triple B rather than the actual price that was paid?

That’s a subjective guess but I’m going to guess probably about a hundred basis points lower in yield.

Wow, that’s a full one percentage point.

Yes, as you go further down the credit spectrum your probability, if default rises quite sharply so your pricing can be as much that, different from say 260-250 basis points of yield pickup in the triple B space and that’s a broad space to 250/350 basis points in the double B space.

We’re going to test your mental arithmetic now. How much over the period of this bond extra then does the country pay?

I’m not going to the do the maths for you. I can’t do it in my head and convert back to that.

In essence you take the period of the bond and you increase by one percent, the interest that you would pay over that period and it’s big numbers.

Exactly and when you borrow substantial sums, which is what you’re talking about there’s not a small amount of money, you borrow substantial sums and you multiply that by a government that’s actually running fiscal deficit which are projected to be in the two and a half to three percent of GDP and GDP is R 4 tn. That means they’re going to be borrowing three percent of R 4 tn for the next few years and that’s just new debt. It’s expensive. The problem with being downgraded is it raises your cost of capital so that the country, a greater portion of the government spend is taken up by interest expenditure which takes away from other programmes you want to run whether it’s social programmes or health care or education or whatever the heck else you want to do with the country, your cost of interest goes up if you get downgraded, which is why it’s such a catastrophic thing for the country.

Read also: Thea Fourie: Downgrade + soft economic data = Recession

Tax receipts that we saw out in the last week were heralded as a step in the right direction. Clearly that didn’t have enough of an impact on the pricing of this Eurobond.

I don’t think people take one or two or three month data as seriously. You look at the budget for the year and whether we’re on track to reach that budget and you look at the medium-term expenditure framework that comes out in October/November and that’s how you assess these things. If you’re looking at short-term on money flows to government, it tricks you all the time because it is not a smooth flow of money to or from government.

It would be like quarterly results if you were thinking of buying a share?

Quarterly results, corporate management tend to smooth, whereas government receipts, they are what they receive. If somebody pays you taxes it gets recorded, they don’t smooth them so it’s very lumpy data.

The big story, I guess is to do with economic growth and that’s not a happy picture at the moment.

Governments are able globally and forever to borrow money on the basis that under macro, macro sense, if you borrow money in an in economy and the economy is growing at rates above your cost of money, that seems like a good idea if you can borrow money at say eight percent and the nominal GDP growth is ten percent let’s say for just, then it makes sense to borrow money so you can grow the economy and that’s how we look at it. When you get into the environment where you’re paying up now, a ten percent for a long-dated debt in South Africa in Rands and you have GDP growth running at point eight percent out on inflation, call it eight percent, your cost of money is greater than your growth of the economy and that puts you into what’s eventually called a debt trap.

You’re having to keep borrowing to pay back debt even though you’re investing in an economy that isn’t growing and so when credit ratings agencies look at several things but a key indicator for them, is the growth of the country. A country that has high debt, if it has high growth, can grow their way out of debt. If they have low growth it goes the opposite way. You get yourself deeper into debt and South Africa is currently in that trap. We are in a low growth environment with high interest costs and that is why the ratings agents amongst all the other reasons that we are all well-versed in, that’s one of the reasons the ratings agents very much have us under watch for downgrade.

Read also: S&P: SA faces downgrade on further policy mistakes, slowing growth

The impact on the man in the street is quite clear from what you’ve said. The economy will continue to go in the wrong direction if we should get into this debt trap and that means you have to pay higher taxes eventually.

I don’t want to be too argumentative but if the man on the street thinks he has an outlook that’s clear then he needs to be disabused of that notion. We are living in an environment right now of political uncertainty and therefore economic uncertainty. As a bond investor I struggle to take a 20 or 30 year review of the nation, of the government debt in South Africa and I can’t have a clear picture of that. Whatever I say today could be proven wrong tomorrow by politics or indeed by economics while the growth outlook looks bad at the moment, we’re going to have point five or point six or point eight percent growth this year as expected. The reality is the Rand has gone down a lot. The reality is that commodities may bordering.

The reality is that maybe China, Europe, Japan, and the US aren’t in as bad a shape as people think and you’re going to get some global growth, and actually our growth outlook could improve next month. The outlook is really not clear at all and there is what the expectations are and then there are the moving parts. If you can get people within this government with the fiscal authorities at national Treasury versus the political authorities in the office of the presidency doing battle, that is very bad for the country and eventually the bond market is a proxy for voting.

There’s an old phrase called ‘bond market vigilantes’ who keep governments in line by increasing or decreasing their cost of debt. The bond market, while it’s had a nice rally after Pravin Gordhan was reappointed, could actually have a sell-off as a political statement against political miss-steps. It is a very uncertain environment, that’s what I’m trying to communicate.

One of the uncertainties is coming ahead in the next couple of weeks when Lungisa Fuzile, the Director-General of Treasury, one of the guys who was supposedly earmarked for ejection during the Nenegate Scandal, his contract comes up for renewal. If they don’t renew, would that be seen in a particular sense by the bond market?

I don’t know that they’re focusing on the particular man. I think the focus of the attention is on two key figures right now and I think Pravin Gordhan and Jacob Zuma. The rest of the cast of characters is more like a bit players, important bit players. Therefore, I think we have to see it in the flow of what might happen. You could wake up tomorrow or next week and find out that the boards of large stake on enterprises have been replaced by a different crowd of people which would be very market positive while at the same time somebody you like doesn’t get reappointed, for example. There are too many moving parts Alec, to actually even say what’s going to happen in two weeks’ time.

What do you an investor, given that we’re in a developing country where politics does trump economics as you’ve just explained?

Yes, that’s also a tricky one because I’m not sure politics trumps economics, it ought to. Right now with the ten-year bond yield at nine point two five roughly, I say I don’t really buy that. Inflation environment going up to the high seven percent range, this year possible in the sevens next year because of the Rand weakness, a ten-year bond just over nine percent doesn’t strike me as very attractive, particularly given the uncertainty and get that as where the market is. I’m not sure what trumps what. The answer to the question, what do I advise they must do? I would not recommend any investors either institutional or retail to buy in long-dated nominal bonds and that’s a pretty bold statement because right now you could buy an R2050 bond yielding just over ten percent.

That’s a nominal bond yielding ten percent, against the long-term inflation outlook, if we have political stability and fiscal stability a long-term refreshed outlook of let’s say six percent; a ten percent yield isn’t that bad. It’s the uncertainty I can’t live with but I wouldn’t recommend buying those because you can’t get your arms around it. Things that are more attractive is inflation in bonds, which are, as the phrase implies, it leads to inflation. They’ll earn a base yield, a real yield, plus the inflation rate. Right now the real yield on the long-dated inflation bond is about one point nine percent and inflation let’s say is going to be seven percent for the next two years, you’ll earn a yield of about nine percent for the next two years, not an unattractive thing, it’s a relative safety space.

Read also: More pain? Inflation surprising SARB, could peak at 8.1% in December – Montalto

If things go really wrong and you’ve got to continue to get an inflationary environment from the fiscus or if the reserve bank loses its credibility and inflation starts going up more you have an inflation hit which is a good core holding. Many years ago they had always said that gold should be a core holding in the portfolio as an inflation hedge. Nowadays inflation bonds are a good core holding of say two to five to ten percent of your portfolio as an inflation hedge similar to your house for example.

Another safety place is cash of course, Money Market funds or even yield-enhanced Money Market funds where you can beat JIBAR behind additional 100-250 basis points at yield with a bit of credit risk and the credits in South Africa are pretty stable, so that’s not a big stretch but slow interest rate risk, it’s shorter-dated but it beats inflation by maybe one percent or one and half percent, so that’s a safety place. I struggle to see equities as a safety place because of their inherent volatility because they are subject to global uncertainty and domestic uncertainty and they are on keep. I think of relatively short-dated inflation bonds, relatively short-dated cash and Money Market instruments, or income funds or short-dated income funds are your safety place.

Andrew, that one point nine percent premium over the inflation rate, is that aligned with a downgrade that everyone is anticipated? In other words, if the downgrade didn’t happen, would that premium over inflation contract?

The domestic inflations market doesn’t really trade on South Africa’s sovereign credit rating, principally because we domestic investors when we by Rands nominated instruments in the government, we consider them credit-risk free. That is to say if the South African government borrows in Euros as they have, a Euro investor has to worry about whether the South African government is going to pay them back in Euros. If they borrow from me in Rands or borrow from you in Rands, the fact is they will pay us back because they can print the money.

They’re not going to default on the debt. They might create inflation; they might inflate the way I look at that. They might print too much money to pay back the debt and that’s why IOB’s are quite good. They don’t have credit risk per se and they give you a hedge against the last recourse of the tyrants which is to inflate their way out of problems. It makes them a really suitable holding for portfolios for that reason.

Read also: SA in Top 5 ‘Most Miserable’ economies – tale of rising inflation, unemployment

That is not going to be affected, that premium over the inflation rate by whatever happens on the sovereign’s downgrade but the impact is certainly going to be seen in the Euro currency or in fact, Dollar bonds that we might be borrowing in.

Yes. Two thoughts there; first, I can’t go as far and say it would have no impact because South Africa’s cost of capital is set by the global market. That does affect domestic price. I’m just saying it’s a second world effect on the domestic inflation bonds. The other thing about the downgrade when it comes, it all depends how it happens. If we are downgraded in anger and with impunity by the range agents, as I say, if they implied it we’re not just going to downgrade you a little bit but you’re being downgraded and we’ll still watch you because we’re going to downgrade you again in the future, our cost of capital will continue to rise in a global market.

If the government makes a major, having made all sorts of promises now to try to retain our credit rating, principally by Pravin Gordhan, if the government does something radically wrong to undermine the credibility of fiscal policy on a one to five year forward-looking view, the range agents will not just downgrade us but they will make continued hawkish aggressive statements implying that they’ll downgrade us again to double D plus, double D, double D minus and then our bonds will continue to trade worse globally. What I’m trying to say is the ‘how’ matter’s. It isn’t just, ‘oh we were downgraded’, and that’s in the price, we could be downgraded with the expectation of another downgrade behind that in which case it is not in the price. It’s all part of this great 2016 uncertainty I’m talking about.

Yes, and that would push up the interest rate that the country would have to pay and being a developing country –

Absolutely, crossing Capital across the economy.

Yes, we have to borrow. Andrew, let’s look at two scenarios. Many investors are seeing it as a binary future for South Africa. The one future would be Pravin Gordhan remains intact, Jacob Zuma leaves. The other one, Jacob Zuma remains intact, Pravin Gordhan leaves. How would the market interpret or how would bonds interpret those two scenarios?

Again, the how matters, in all of the transition in the presidency we’re probably very well-received. The ascendency of people who back the constitution will forcefully, and stand for governance and fiscal rectitude would be very good for the bond market. Again will it be quite that simple, probably not. On the other hand if Pravin Gordhan left in the next say six months, it would probably be catastrophic. We would be back to ruin in December and I don’t think there’s many ways that government, as it stands could paper over that rift with that lack of confidence.

Right now we are hanging our hat on a budget that was presented a few weeks ago which shows reasonable fiscal rectitude on a three-year forward view. However, it’s not like they delivered a lot this year. We are betting that they will be able to deliver lower expenditure and reasonable revenue in the next three years. You start rolling over the ministers of finance and creating uncertainty in that and the bond market is not going to like it at all. The bond market will sell off.

How badly, what is that impact likely to be or what could it be?

Let’s put it this way. In December when Nene was fired and the new minister who was appointed, the unknown minister who was appointed with questionable competency, the bond market sold off in what, three days by 200 basis points from roughly speaking the eight and a half percent level to the ten and half percent level. I haven’t seen a better market like that since the late 1990’s. That’s a four standard deviation event in the bond market and it’s a clear statement of lack of confidence that the fiscal rectitude has just been thrown out the window. That’s why that Monday morning or that Sunday night when Pravin Gordhan was reappointed, the bond market rallied back quite a bit on Monday and thereafter, so you could see such an event again is what I’m saying.

Had he not been reappointed we would –

It would have been a very bad Monday. I can tell you this market was not going to stop.

We’re not going to stop at ten and a half?

Nobody was going to get into the way of that train. Rates were going up and if they’re not up in a radical reversal the rates would have continued to go up. How could you hand over the keys to the Treasury to an unknown political appointee who didn’t come through the system and you have no confidence in their ability to run a fiscus and then expect institutional or retail investors to be holding 30 year government bonds? It would have been a crazy proposition and the mood of the market was very dark.

Where is it now?

Funny enough it’s surprisingly sanguine. Things are under control and Pravin is secure and while they’re chirping at him from the side-lines about the road unit, there may or not have been road, that there’s a belief in the great cooperation between business and the Department of Treasury. There’s a belief, I think that the ANC broadly speaking is getting its mind right about running the country and I don’t think there’s any real belief that the ANC is going to stop running the country by the way, although there’s talk about a split but I’m not a political analyst. The market seems pretty comfortable at the moment. As I say the yield on a ten-year bond at nine and a quarter percent’s going into a seven and a half percent or higher inflation environment, actually is a pretty good vote of confidence in the country right now.

With the growing cause for the president to step down concerns that he has allies who won’t take easily to that if it does happen, is that in the price as well?

I don’t think so. As I said, I think we’re going to be sitting in a very emotional market this year because it isn’t just domestic factors, it’s what the feds going to do, it’s what the global growth environment looks like, and the global industry environment looks like. There’s a lot of moving parts this year and it’s hard to put your arms around that but I’m getting on uncertainty and that’s why I’m saying keep your insured risk relatively lower than you would normally.

Andrew Canter is the Chief Investment Officer at Futuregrowth and this special podcast was brought to you by Futuregrowth.

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