South African bonds have found favor with emerging markets fixed income investors. Given the rough climate the economy and the political establishment is going through, many expected the country’s assets to fall off investor radars until signs of improvement surfaced.

However, as the graph below shows, this is certainly not the case.

By the end of September 2017, South African bonds attracted net inflows worth 69 billion rand ($6.6 billion) for the year, according to Bloomberg data.

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Given that Moody’s is the only rating agency which rates both foreign and local currency long-term issuer ratings of South Africa as investment grade (S&P Global Ratings has slashed the country’s foreign currency ratings to junk while Fitch has both ratings as junk), this level of investment interest is exceptional.

Fueling the bond rally

The reason for such visible interest in South African bonds is actually quite simple: high bond yields amidst relatively low yields in developed markets.

The 10-year bond yield in South Africa is over the 8.8% level at present compared to 0.47% in Germany, 1.35% in the United Kingdom, and 2.4% in the US.

Given expectations of low inflation, a rate cut by the central bank, and the possibility of further monetary easing to support the economy has continued to attract inflows to bonds.

But there are risks that investors should consider which could impact both South African bonds and equities.

Red flags

The political back and forth is the foremost threat to bonds and equities, particularly the former as overseas investors have already turned away from the country’s stocks. The African National Congress (ANC), which will hold a conference in December, is going to strongly influence market movement leading up to the event.

The susceptibility of markets to political developments can be seen from the fact that the recent cabinet reshuffle had hurt stocks and the South African rand quite badly.

The economy is another major issue for the country. The lone rate cut effected by the central bank in July 2017 was a desperate attempt to get the flagging economy going. Earlier in October, the central bank said the country’s economy may not attain a 2% annual growth level in the near-term due to the uncertain political environment.

A poor economy puts strain on government finances as revenue falls short, which is the case with South Africa. This can have an adverse effect on the bond market by pushing yields up and thus reducing gains for institutions already invested in the country’s bonds.

This can also have an impact on the country’s ratings. Moody’s and S&P are expected to review their stance on the country in November, and though a major action may not take place ahead of the ANC conference in December, the government’s financial situation may give an indication towards action either at the end of 2017 or in early 2018.

And then there’s the rand. As the graph above shows, the unit is weakening again. A weak domestic unit is detrimental to returns on local currency-denominated bonds as well as equities.

Thus, at this juncture, it would seem as though South African bonds and equities do not present an attractive entry point until further clarity on events unfolding later this year.

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