Leaning into the curve

South Africans may be justifiably concerned that the government is overrunning its fiscal deficit target, adding to our already considerable debt burden, but this darkening cloud has a silver lining for investors – the negative news is priced into the bond market, which is offering attractive real returns.

At Budget time in February, National Treasury was relatively bullish about meeting its fiscal deficit target of 3.9% of GDP. Fast-forward a few months, and Treasury’s financial year first-quarter figures are not looking good: revenue is down and expenses are up, and South Africa is on track for a fiscal deficit to GDP ratio of about 5%, which translates roughly into R70 billion additional debt.

Revenue and expenditure

Looking at income, by June last year, the government had raised about 27% of its revenue target. This year the June figure is 23%.

The main reason for the drop in revenue is that our mining companies are contributing far less in corporate tax – export commodity prices are down 33% over the last 12 months. Volumes are also lower due to many own goals inflicted on our economy. The profits of AngloPlats, for example, have dropped 70% year-on-year.

For the last couple of years, the commodity windfall boosted miners’ share of corporate tax in South Africa to about 28%, from pre-Covid levels of around 10%. We’re now seeing a reversion to the more realistic pre-Covid figure.

On the expenditure side, the government is not reining in spending as promised in the Budget. Soon after the Minister’s Budget Speech in Parliament, the public sector wage settlement came in at R40 billion over the target. Almost immediately out of the blocks expenses were higher.

Bond risk premium

It’s unlikely, with an election coming up next year, that the government will change course to realign with its 3.9% target by reducing expenses and cutting services. Thus, to cover the increased deficit, it will be forced to issue bonds. However, foreign investors have consistently been reducing their exposure to South African bonds over the last three years. The net result is that higher yields have been necessary to successfully raise the required funding.

This is where the good news for investors comes in – the upward pressure in yields means that investors are being compensated for these known risks. A couple of years ago the yield on the SA 10-year bond was less than 9%; it is now just under 12%.

These risks aren’t only reflected in the absolute level of yields available. Comparing South African and US long bond yields, we can see that the gap has remained elevated since 2020. This is an indication of the SA-specific risk that has been priced into South African bonds.

Real returns

If inflation remains range bound around 5.4%, which we saw in June, the elevated yields of 11.5% means that investors could earn a real return of around 6% from holding SA government bonds, even if the outlook doesn’t materially improve.