Transcript “How to reduce debt costs in Southern Africa” , Johannesburg, 25/26

The South African bond market:
A practitioner’s perspective of progress,
problems and prospects
Presentation to OECD seminar on “How to reduce debt costs in
Southern Africa” , Johannesburg, 25/26 March 2004
Gordon Smith
Deutsche Bank AG
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aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider
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2
Structure of presentation
 Executive summary
 Macro drivers and relative asset performance
 Impact of fiscal policy on SA’s bond market
 Maturity profile and yield spread dynamics
 FX risk; benchmark and ownership issues
 Some conclusions and suggestions
3
Executive summary
 SA’s bond market reflects the economy in which it operates;
notably declining savings/low growth limit issuance capacity
 Legacy effects still cause most asset allocation professionals to
shun bonds even as their recent returns have trounced equities
 Impressive fiscal reform has facilitated market consolidation, as
apparent in growth in offshore sovereign/local corporate issues
 Yet, rand volatility/sovereign credit considerations cap foreign
issuance while strong cash-flows meet corporate funding needs
 The ‘off-index’ EM benchmark status of local bonds has held
back foreign participation in the market, in contrast to equities
 A falling inflation premium/further sovereign credit re-rating
should continue to sustain a hesitant unwind in real bond yields
4
Macro drivers and relative asset performance
 SA bond market: Predictor of economy/policy
 A very brief history of SA’s macroeconomics
 SA yield dynamics and structural adjustment
 SA bonds outperform equities and inflation
 Legacy drag on institutional asset allocation
5
SA bond market: Predictor of economy/policy
21
10Y less 3M
benchmark
(led 12 mths,
lhs)
10-year SAGB yield (%)
Base rate* (%)
19
17
15
13
11
9
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1987
source: I-Net Bridge; Deutsche Securities
1989
*Pre-April 1998 Bank Rate; post-April 1998 Repo Rate
7
1988
IP (12MMA,
% y-o-y, rhs)
source: I-Net Bridge; Deutsche Securities

Economic efficacy: Yield curve predicts IP (most cyclical, large component of GDP) by
about a year. Current spread predicting sustained turnaround in IP cycle later this year.

Policy efficacy: Bond investors/SARB constantly keeping an eye on each other, with long
rates usually leading short rates by six months, except during sudden “crisis” events.
A very brief history of SA’s macroeconomics
6
Gross savings
(% GDP, lhs)
source: I-Net Bridge; Deutsche Securities
Gross capital formation
(% GDP, lhs)
5-year trailing real 10Y SAGB
yield(%, rhs)

Macro theory would posit transmission mechanism of falling savings => falling investment
=> rising real rates => lower growth. SA delivered a textbook response after 1980.

Open economy macro theory would posit need for rising real rates on abolition of dual
currency regime in 1995, allowing current account deficit to be adequately funded
7
SA yield dynamics and structural adjustment
Real GDP volatility (5-year trailing average, %)
10-year SAGB yield
CPI inflation
CPIX inflation
source: I-Net Bridge; Deutsche Securities
source: I-Net Bridge; Deutsche Securities

Falling cyclicality has been primarily due to halving or more of sustainable inflation since
onset of 1) real rate regime (from 1988) and 2) exchange control relaxation (from 1995)

Lagged response of yields to inflation evident in rising real yields, reflects bond investors’
vigilantism towards inflation risk and thus sustainable achievement of 3-6% CPIX target
SA bonds outperform equities and inflation
1.5
ALSI relative to ALBI Total Return
1.3
1.1
0.9
0.7
0.5
source: Deutsche Securities
2003
2001
1999
1997
1995
1993
1991
1989
1987
0.3
1985
8
Equity
(Total return, %)
1986
56.5
1987
-4.7
1988
14.9
1989
55.5
1990
-5.1
1991
31.0
1992
-2.0
1993
54.7
1994
22.6
1995
8.8
1996
9.3
1997
-4.5
1998
-10.0
1999
61.3
2000
-0.1
2001
29.1
2002
-8.2
2003
-0.9
Compound ave return 14.7
Bonds
(Total return, %)
35.9
14.8
8.3
21.5
16.2
14
27.3
31.5
-9.3
29.6
6.3
28.7
4.8
29.4
19.3
17.8
16
14.8
17.6
Inflation
(CPI, %)
18
14.7
12.6
15.3
14.6
16.2
9.6
9.5
9.9
6.9
9.4
6.1
9
2.2
7
4.6
12.4
0.3
9.8
source: I-Net Bridge, Deutsche Securities

With lower cyclical economic volatility, primarily due to sustained macro-level reforms,
bonds have structurally outperformed equities since 1986, but markedly so since 1994

As a result, bonds have been a superior inflation hedge. While this is a dire verdict on
risky asset returns in the last decade, it reflects the high costs of structural adjustment.
Legacy drag on institutional asset allocation
9
80
Core Institutional asset allocation (%)
70
60
50
source: Alexander Forbes
40
30
20
10
0
3Q01
4Q01
1Q02
Equity
2Q02
3Q02
4Q02
1Q03
2Q03
3Q03
4Q03
Fixed income

SA fund managers have been mandated to relatively outperform, thus institutionalising a
risk bias towards equities, which are also thought to have better inflation-hedge qualities

Where we have seen bond investors’ reticence to fully discount a sustained fall in inflation
risk, it is no real surprise that this pro-equity asset allocation legacy continues to persist
10
Impact of fiscal policy on SA’s bond market
 Steady not stellar growth in SA bond market
 Some diversification in concentrated market
 Fiscal conservatism drives sovereign rating
 Shifting issuance bias in SA bond market
 Cash-flows funding private capital intensity
Steady not stellar growth in SA bond market
450
100
160
400
90
140
source: I-Net Bridge; SARB
source: Deutsche Securities

Bond capital raising will be a function of the economy’s savings constraint; as we have
seen, SA’s reforms have helped to dampen GDP risk but not yet revive trend growth

In US$ (numeraire) terms, while SA’s bond market is barely changed from a generation
ago, it remains comparable, in (US$) GDP terms, to Russia, China and South Korea
Argentina
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
0
Turkey
Public sector bond market cap (US$bn, rhs)
0
0
Philippines
10
Indonesia
50
20
India
20
Public sector bond market cap (ZARbn, lhs)
Thailand
100
40
Brazil
30
Malaysia
150
60
Poland
40
South Korea
200
80
South Africa
50
100
China
60
250
Domestic debt/GDP (%)
120
Russia
70
300
External debt/GDP (%)
Mexico
80
350
1986
11
12
Some diversification in concentrated market
SA Foreign debt
13%
Turnover ratio*
ZAR74bn
Corporate
13%
ZAR71bn
ZAR352bn
ZAR54bn
SA Government
Bonds
64%
Sub-sovereign
10%
2002
2003
R150 (2004/05/06)
61.2
48.3
R194 (2007/08/09)
21.5
26.7
R153 (2009/10/11)
30.6
33.5
R157 (2014/15/16)
25
19.9
R186 (2025/26/27)
17.6
10.3
R189 (ILB, 2013)
2.9
0.9
R197 (ILB, 2023)
2.3
2.3
* Market turnover/nominal outstanding issue
source: BESA; SARB

source: SA National Treasury
In their SA bond market exposure, investors face:

Less domestic sovereign dominance with growth in foreign and corporate issues

Concentrated liquidity in benchmark issues; SAGB, parastatal and corporate
Fiscal conservatism drives sovereign rating
55
0
Net govt. debt/GDP (%, lhs)
Budget deficit/GDP (%, rhs)
6
-1
50
BBB/better?
-2
5
-3
4
BB+
-6
Debt costs/GDP (%)
source: SA National Treasury
06/07
05/06
03/04
02/03
97/98
96/97
06/07
05/06
04/05
03/04
02/03
01/02
00/01
99/00
98/99
97/98
96/97
95/96
94/95
93/94
92/93
-8
91/92
30
Projected
S&P Credit Rating
3
04/05
-7
01/02
35
00/01
-5
99/00
Projected
40
BBB-
-4
98/99
45
90/91
13
source: SA National Treasury, Standard & Poor

Given a budget deficit overhand from political settlement, reducing public sector debt
was the anchor input of a wider strategy to reduce inflation and liberalise the economy

The financial payback for a steady lowering in debt service costs has been a steady
improvement in SA’s credit rating, from “junk” to “investment” grade in the last decade
Shifting issuance bias in SA bond market
100
70
Total foreign debt (ZARbn)
90
Corporate bond market cap. (ZARbn)
60
80
70
50
60
40
50
30
40
30
20
20
10
10
source: SARB
2003
2002
2001
2000
1999
1998
1997
1996
1995
0
1994
14
0
2001
2002
2003
source: BESA

SA’s improving credit rating has continued to pave the way for more global issuance,
subject to Treasury’s self-imposed current 80% (local)/20% (foreign) funding “rule”

Improving deficit and debt profiles, coupled with a steadily rising share of foreign
issuance has substantially removed a crowding-out effect to abet corporate issuance
2004
15
Cash-flows funding private capital intensity
Share of aggregate savings (%)
Corporates
Private vs public sector capital formation (1995 Rbn)
%/GDP
1970
1980
1990
2000
09/’03
Pvt.
10.0
10.9
9.6
11.7
12.8
Pub.
9.2
10.6
5.7
3.9
4.2
Public
Households
Private
General government
source: I-Net Bridge; Deutsche Securities
source: I-Net Bridge; Deutsche Securities

With aggregate savings, a lower budget deficit has on a relative basis been taken up by
lower household saving, reflecting low income tax cuts and rising retail credit intensity

For SA’s financial intermediaries, as companies have met rising fixed investment needs
from flush cash-flows, this has meant growth in bank credit relative to bond issuance
16
Maturity profile and yield spread dynamics
 Towards a smoother SA issuance profile
 Foreign issues: smallness means lumpiness
 Country premia more relative than absolute
 Credit vs. liquidity risks in corporate spreads
 Spreads consistency reflects efficient market
 A note on inflation-linked bonds (ILBs)...
source: SARB
2034/35
2027/28
2026/27
2025/26
2023/24
2018/19
2016/17
2015/16
2014/15
2013/14
2012/13
2011/12
2010/11
2009/10
2008/09
2007/08
2006/07
2005/06
2004/05
17
Towards a smoother SA issuance profile
35
Maturity profile of domestic marketable bonds (ZARbn)
30
25
20
15
10
5
0
Foreign issues: smallness means lumpiness
2.0
Maturity profile of government foreign debt (US$bn)
1.8
1.6
1.4
1.2
1.0
0.8
0.6
0.4
source: SA National Treasury
2021
2020
2019
2018
2017
2016
2015
2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
0.0
2022
0.2
2004
18
Country premia more relative than absolute
800
1050
350
Spread over USTs (bp)
Country risk premium* (bp)
700
950
600
850
500
750
650
Average: 246bp
150
550
200
EMBI+ (LHS)
450
100
SA US$ 10Y (RHS)
source: I-Net Bridge; Bloomberg; Deutsche Securities
Jan-04
Oct-03
Jul-03
Apr-03
Jan-03
1996 1997 1998 1999 2000 2001 2002 2003 2004
50
Oct-02
* 10Y SAUS$ - 10Y UST
350
Jul-02
100
0
250
200
400
300
300
Apr-02
19
source: I-Net Bridge; Bloomberg; Deutsche Securities

While SA’s sovereign risk premium has improved since 1996, so too have many other
country ratings, especially the EU convergence trades, which have leap-frogged SA

Significantly, in the tightening of EM spreads since 4Q02 to risk levels last seen in 1997
(i.e. pre-Asian crisis), SA’s credit returns have mostly mirrored those of EM’s generally
Credit vs. liquidity risks in corporate spreads
20
160
Spreads to SAGB equivalent (bp)
Corporate (NED1)
140
Parastatal (WS03)
source: I-Net Bridge; Deutsche Securities
120
100
80
60
40
20
0
-20
Sep-01
Mar-02
Sep-02
Mar-03
Sep-03
Mar-04

Sub-sovereign (parastatal) and corporate debt reflect appropriate spreads of underlying
credit or earnings risk: tighter/stable for annuity cash-flow operations such as utilities

Tighter parastatal spreads also reflects implicit govt. backing of default risk. As elsewhere,
credit quality determines relative spread elasticity to benchmark SAGB yield dynamics.
Spreads consistency reflects efficient market
21
300
5/2 yr spread
10/2 yr spread
200
10/5 yr spread
100
source: Deutsche Securities
0
-100
2-year
5-year
Mean: 34bp
SD:
73bp
10-year
Mean: 51bp
SD:
96bp
-200
-300
1995
1996
1997
1998
5-year
1999
2000
2001
Mean: 17bp
SD:
29bp
2002
2003
2004

For a yield curve with reliable leading indicator properties, it follows that changes in
relative spreads reflect appropriate risk-adjusted “bets” of bond investors

Where liquidity has been dominant in the 5-year and 10-year areas of the curve, most
directional “bets” are in terms of 2-year/5-year or 2-year/10-year spread trades
A note on inflation-linked bonds (ILB’s)...
7
9
ILB issuance as % of cumulative total net issuance
Breakeven inflation rates (%)
10y
20y
5y
30y
6
8
5
7
4
3
6
2
5
1
source: SARB; SA National Treasury; BESA
Sep-03
Mar-03
Sep-02
Mar-02
Sep-01
Mar-01
Sep-00
Mar-00
Sep-03
Mar-03
Sep-02
Mar-02
Sep-01
Mar-01
4
Sep-00
0
Mar-00
22
source: I-Net Bridge; Deutsche Securities

In tandem with the introduction of the inflation target in 2000, National Treasury has
issued four ILBs across the maturity spectrum, currently accounting for 6% of issuance

While still relatively illiquid, it is possible to derive from their real yield differentials
distinct discounted future inflation expectations for comparison to consensus forecasts
23
FX risk; benchmark and ownership issues
 SA bonds are better insulated from FX risk
 SA in EM: Small in bonds but big in equities
 FPI flows reflect benchmark characteristics
 Foreigners are mature owners of SA assets
 Structural bond ownership patterns persist
24
SA bonds are better insulated from FX risk
25
1400
Currency risk premium* (bp)
1200
Annual volatility of ZAR/US$ (%)
20
1000
15
800
600
400
10
Average: 537 bp
5
200
0
* 10Y SAGB -10Y SAUS$
0
1996 1997 1998 1999 2000 2001 2002 2003 2004
source: I-Net Bridge; Deutsche Securities
1996 1997 1998
1999 2000
2001 2002 2003
source: Deutsche Securities

The recent profile of FX risk is ambiguous: on one measure (relative yield derived), SA
currency risk has declined but on another (FX volatility derived) it has increased

Since the former is more stable, one could conclude that local yields have become less
sensitive to “pure” FX risk, a conclusion consistent with an improving sovereign rating
SA in EM: Small in bonds but big in equities
25
25
20
20
Benchmark EM bonds:
Weight in EMBI+ (%)
18
16
Benchmark EM equities:
Weight in MSCI EMF (%)
14
15
12
10
10
8
6
5
4
2
0
source: JP Morgan
Colombia
Venezuela
Pakistan
Jordan
Morocco
Egypt
Czech Republic
Peru
Philippines
Argentina
Hungary
Poland
Turkey
Indonesia
Chile
Thailand
Israel
Malaysia
Russia
India
Mexico
China
Brazil
Taiwan
South Africa
Korea
Brazil
Mexico
Russia
Turkey
Philippines
Colombia
Venezuela
Peru
Malaysia
Bulgaria
Ecuador
Argentina
South Africa
Panama
Ukraine
Poland
Nigeria
Morocco
0
source: Morgan Stanley Capital International

Dedicated capital flows are an important source of capital for EM’s. For such investment,
bond investors are benchmarked to the EMBI+ and equity investors by MSCI’s EMF

Financial sanctions and an alternative foreign debt restructuring left SA with a low
EMBI+ weight but established, large companies ensured SA a high MSCI EMF weight
26
FPI flows reflect benchmark characteristics
US$ billion
US$ billion
Bonds
Equities
Equities
Bonds
source: I-Net Bridge, Deutsche Securities
13-week accumulation
source: I-Net Bridge; Deutsche Securities

Following the abolition of the Finrand and inclusion in benchmark indices, SA could
capitalise on FPI as the main source of financing a renewed current account deficit

Given SA’s apposite benchmark status in bonds and equities has seen latter dominate
FPI inflows, but “off-index”, opportunistic bond inflows can be temporarily large
27
Foreigners are mature owners of SA assets
18
Gross foreign ownership of domestic debt (US$bn)
30
Gross foreign ownership of domestic equity (US$bn)
16
25
14
12
20
10
15
8
6
10
4
2
5
0
1995
1996
1997
1998
1999
2000
Public authorities
Public corporations
Banking sector
Non-bank sector
source: SARB
2001
0
1995
1996
1997
Banking sector
1998
1999
2000
2001
Non-bank sector
source: SARB

Foreign asset and liability position (for latest 2001 data) confirms foreigners’ preference
for domestic equity over bonds, with a notable public vs. private source of funding split

Significantly, in US$ terms, it would appear that without further structural changes to
SA’s asset markets, there is little scope for foreigners to raise their ownership stakes
Structural bond ownership patterns persist
28
100%
Ownership of long-term domestic government debt
80%
source: SARB; I-Net Bridge
60%
40%
20%
0%
1990
PIC
1991
1992
1993
1994
SARB
1995
1996
1997
Banks
1998
1999
2000
2001
2002
2003
Non-bank private sector

Even as the PIC has sought to diversify its historic asset allocation bias from bonds to
equities, this has been achieved via cash-flows, especially during debt-buyback years

By being on the other (asset allocation) side of the market, the PIC posted impressive
relative returns from its high bond exposure, helping GEPF to close its net funding gap
29
Some conclusions and suggestions
 Treasury deserves plaudits for macro restructuring that has
helped to stabilise economy and consolidate the bond market
 It remains critical that inflation targeting success completes this
contribution to a sustained re-rating in SA’s real debt costs
 Lower real yields should be matched by further sovereign credit
re-rating, and thus an ability to unwind bond market overhangs
 Critical to this process will be: boosting bonds’ benchmark asset
allocation; reducing PIC dominance and more off-shore issuance
 This would facilitate more foreign participation as well as boost
capacity for bond financing of new net fixed capital formation
 The bond market is merely one financial intermediary for savings
and investment, which remain a function of economic growth
30
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or view in this report.
Gordon Smith
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Total return expected to be between 10% to -10% over a 12-month period.
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