The January rally took away most of the interesting fixed income opportunities that we identified at the beginning of the year. In Europe, for example, after the Itraxx crossover touched a 3-year high at 373bps at the beginning of the year it quickly retreated to 309bps just one month later. Similarly, in the United States, the high yield credit default swap index also touched a 3-year high at 484bps at the end of December and retreated quickly to 362bps after the Fed’s policy-setting in January.
The rally did not just involve high yield corporates –many investors grasped opportunities within the investment grade and the emerging markets spaces too. Those who were not able to take advantage of higher credit spreads at the beginning of the year were left empty handed and now wonder whether the only thing to do is to accept current prices or to wait for another episode of volatility that would reprice some of the assets.
Forecasting the future is a difficult and imprecise science, therefore the only option left for investors is to keep looking for higher yields, perhaps considering some more speculative opportunities. Within this context, South Africa may be the risky but potentially rewarding target that investors have sought.
South Africa offers one of the highest yielding sovereign bonds in the world. The benchmark South African bond with December 2026 maturity (ZAG000016320) is yielding approximately 8.7%. At the same time, the south African rand is extremely weak compared to its historical averages and there are signs that the political uncertainty and volatility that we experienced under the leadership of President Zuma will soon come to an end thanks to the new government that is more conscious about the challenges the country is facing.
Cyril Ramaphosa became president of the African National Congress, the country’s most powerful political bloc in December 2017 and subsequently replaced Zuma as the country’s president in an unopposed selection process upon the latter’s resignation.
Ramaphosa will spearhead the ANC’s campaign in the national elections in May this year, also seeking to consolidate his authority and his party’s leading position. Although these elections constitute an uncertainty for investors, it looks like the ANC is pulling out all the stops to have their man re-elected.
Ramaphosa using last week’s State of the Nation address as a propaganda opportunity in order to show the whole world that he understands where risks and opportunities lie, touching on the most sensitive political topics at the moment. First, he made clear that he has a plan in place to enhance south Africa’s economy: he wants to focus on promoting a business-friendly environment for investors and he wants to restructure state owned enterprises, in particular the Eskom electricity public utility in order to avoid a systemic economic problem. Also, the president reinforced the message that he will not protect the ANC from corruption charges and that he’s committed to eradicating corruption from politics completely.
Ramaphosa’s address at the SONA underlines his commitment to changing the ills and inequities of Zuma’s presidency. However, in terms of winning the elections, this speech raises a few questions:
1: In the case of Eskom, will he be able to make the necessary reforms in order to restructure the company without losing the
support of Cosatu, the South African trade union federation? It is hard to give an estimate of the power of unions among citizens,
but in the past they have proven to be a deciding factor in politics, and Ramaphosa may need their support in the elections.
2: Will the ANC itself survive the corruption scandal? Angelo Agrizzi, a former executive of services company Bosasa, has testified that
the company had paid hefty amounts of bribes to ANC officials over the years.
Although the results of the elections far from certain, opposition parties such as the Democratic Alliance and the Economic Freedom Fighters are having their own issues in their campaign and at the moment, it seems that the ANC is playing all the right cards to stay at the power.
If the ANC wins the election in May we can expect South African bonds as well as the south African rand will rally because it seems that change under Ramaphosa is both possible and concrete. We must remember that the bulk of South African sovereign bonds are held by international investors. As Ramaphosa’s ANC is seen as conscious of the economic challenges ahead and is willing to address them, its re-election in May would likely trigger stronger demand from foreign investors.
But what a re-election of Ramaphosa does not solve is the structural challenges that the country is facing due to the huge debt burden of Eskom. More than 60% of Eskom debt is state guaranteed, and since the company is running with costs related to debt servicing close to two times its EBITDA, and interest payments on its debt consume almost all its earnings, it is safe to say that the company is very close to bankruptcy. This leave very few restructuring solutions to the South African government besides a write-down of debt or a decrease of interest payments. Unfortunately, these actions would take a toll on government funding costs and probably would trigger further rating downgrades, especially from Moody’s which is the only rating agency to have kept the country in investment grade territory.
This is why we believe that although South African sovereigns may represent an opportunity in light of the elections of May, it is important to wait for further details from the current government regarding the restructuring of Eskom. Until this point is clear, it will be impossible to say whether the government has a concrete plan that would isolate Eskom’s issues from the country’s sovereigns.
And as experience teaches it is better to be patient and enter in the market at the right time rather than rushing in and realising too late that higher yield is also a reflection of higher risk.
