Bonds – ZA Economist

To the extent that anyone offshore actually noticed SA political developments last week the reaction must be regarded as benign. The extra yield provided by SA government US dollar denominated (Yankee) bonds over the yield on similarly dated US Treasuries declined last week, leaving the SA Sovereign risk premium close to its historic lows and its lows of the past 12 months.

The rand had a good week, gaining about 2% on a trade weighted basis, which has left rand still well ahead of its year ago value. These credit ratings and exchange rate trends will be very helpful in restraining SA inflation and welcome to the Reserve Bank struggling to avoid having to raise interest rates.

The news on the exchange rate was well received in the bond market. The difference between the yield in rands on long dated RSA bonds and the long dated US Treasury Bonds (which may be regarded as the SA risk premium) also narrowed last week by about 20bps to about 5.20%. This yield gap has remained within the five to six per cent range over the past 12 months. It may be regarded as representing the rate at which the rand is expected to depreciate against the US dollar over the long run.

If the rand loses an average 5.2% a year over the next 10 years, investors in RSA and US Treasury Bonds will have broken even. If the purchasing power of the US dollar and the rand is thought to determine exchange rates in the long run, then this yield gap will also represent the difference between expected inflation in the two currency areas. The bond market offers explicit compensation for bearing inflation risk. Long dated RSA bond holders are receiving an extra 6.3% for holding vanilla bonds rather than their inflation linked alternative. This yield gap has remained persistently at this high level over the years though it declined by 15bp last week.

In the US the inflation compensation is currently 2.35%, indicating that inflation in SA is expected to average about 4% higher in SA than the US over the longer term.

The significant electoral swing recorded at the nationwide municipal elections to the DA was enough to encourage the opposition but was not enough to cause anything like panic in the ranks of the ANC. The true democratic credentials of the ANC will perhaps only be fully tested when it is in danger of losing power. This still seems a long way off and maybe for the market place and its state of mind this is just as well.

To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View: Daily View 23 May: SA markets: Did anyone offshore notice the SA elections?

The nuclear cloud hanging over Japan lifted on Friday. Japan can get back to work and begin the rebuilding of its economy sooner rather than later. Relief that the radiation damage to Japan would be limited improved the outlook for the global economy to which equity markets responded very positively over the past two trading days. Equity markets are now back to the levels of 10 March, the day before the Tsunami struck.

US Treasury Bonds, and especially their inflation protected variety (TIPS), benefitted from their safe have status. This left compensation for bond holders bearing inflation risk largely unchanged. This compensation (or what may be regarded as inflation expectations) is shown in the difference between vanilla bond yields and their inflation protected equivalents.

While US Treasuries predictably acted as safe havens, so somewhat surprisingly, did US corporate bonds. The high yield, so called Junk Bonds have held up particularly well through the recent turbulence.

The strength of the US corporate bond market reflects well of the balance sheets of the average US non-financial corporation. It also speaks well of the recovery prospects of the US economy. The case for equities, especially those well exposed to the global economy, remains a strong one, given what we have argued are undemanding valuations. And given the dramatic events of the past few weeks the markets are back to where they were and therefore continue to offer value in our judgment. That the markets could absorb all that nature and engineering fallibilities threw at them, might indicate less rather than more risk to the economic and earnings outlook.

To view the graphs and tables referred to in the article, see Daily Ideas in todays Daily View: Equity markets: Back to square one